April07 Q8

[NeedToQualify]

The acted solution with a currency swap leaves the japanese bank with currency risk since it is receiving GBP 4.5% and paying GBP 5.75%.

It doesn't seem correct since the purpose is to remove this risk.

Any thoughts?

 

[Davee]

I cant find this question in the Revision booklets?

 

[Meldemon]

... and there is no mention of a swap in the examiners solutions either

if you can post more info from the Acted solution we can try to figure out what they are getting at...

 

[NeedToQualify]

It's from ASET.

I agree with the examiner's solution since a forward would hedge the currency risk.

But the currency swap suggested by ACTED doesn't.

It's a swap to make 2% Yen payments and receive 4.5% GBP. The japanese bank borrows at 5.75% GBP.

So I think the currency swap leaves the japanese bank with currency risk since it is receiving GBP 4.5% and paying GBP 5.75%.

 

[Meldemon]

I think we would need to apply a hedge ratio to make it work, so here goes (in simplified terms!):

• For every GBP 100 borrowed, a coupon of GBP 5.75 will be payable
• The gilt (GBP 4.5% / JPY 2%) swap will provide a coupon of GBP 4.5 per GBP 100 nominal
• So we would need to enter into 5.75/4.5 = 1.28 swap contracts to fully hedge the risk

This would be the case if a standard gilts swap is used, i.e. not having an OTC swap. We also need to earn 1.28 * 2% = 2.56% (JPY) from our investment to service the swap agreement.

If an OTC swap was used, we could probably engineer it so that we swap 2.56% JPY for 5.75% GBP, but would involve fees to an investment bank to do so, so perhaps it is cheaper to just use a gilts swap and increase the number of contracts entered into? I don't think we can swap 2% JPY for 5.75% GBP - that's too much risk for any counterparty to take on.

Guess the assumption underlying is that the amount borrowed would not be invested in JPY gilts, but in the business somewhere, and would therefore be expected to return more than just the gilt rate (or else why borrow in the first place).

I hope this helps - I'm a bit rusty on currency swaps!

 

[NeedToQualify]

1) can we get non-integral swaps/derivatives?

2) Isn't it possible to just have a swap which retains the net payment ?
i.e. 4.5%GBP - 2% Yen= 2.5% GBP

To keep the 2.5%, we could have a swap to receive 5.75%GBP and pay 3.25% Yen

i.e. 5.75%GBP - 3.25Yen= 2.5% GBP

This would remove the currency risk since we are borrowing 5.75%GBP and receiving 5.75%GBP from the swap counterparty

Ofcourse ignoring fees.

What do you think?

 

[Meldemon]

1) don't think so, I just used 100 nominal to make the calculations nice and simple - when given the actual loan amount and standard contract size we can calculate the nearest number of swap contracts needed to hedge as close as possible

2) I think the JPY 2% is equivalent (after adjusting for currency) to the GBP 4.5% (following logic of examiners calculation of return on investment in JPY terms), that is, GPB 4.5% = JPY 2%. The question states that "You should assume the yield curve is flat across all maturities in both the sterling and the domestic market"- I would say this hints that the only difference in risk free yields relates to currency movements over time (assuming all gilts are risk free, if Japan had 0% inflation the UK would have 2.5% inflation, and this is the only thing affecting relative currency movements).

So 3.75% yen (2% + 1.75%) would be worth 3.75%-2%+4.5%= 6.25% Sterling - more expensive than borrowing in Sterling direct.

Therefore, it is irrelevant whether one invests in Japanese or Sterling gilts. The difference is the spread over gilt rate available on borrowing in Sterling or Yen, with the Sterling terms being better - if the investor entered into a Yen loan, a return of 3.75% would be needed on the investment to service the loan. By borrowing in Sterling and entering into the swap the required return on the investment reduces to 2.56%.

...still ignoring fees!

 

[NeedToQualify]

1
So 3.75% yen (2% + 1.75%) would be worth 3.75%-2%+4.5%= 6.25% Sterling - more expensive than borrowing in Sterling direct.

QUOTE]


Following the same reasoning...

So 3.25% yen (2% + 1.25%) would be worth 3.25%-2%+4.5%= 5.75%

Shouldn't this be the solution?

 

[Meldemon]

I think the problem is that I am assuming we can get straight gilt swaps in the market (no margin)... but not necessarily specifying terms to swap at a specified margin over the gilt rates in the two countries. I think the original issue was the Acted solutions using gilt-swaps (I don't have ASET so can't see their full comments).

If we are able to design our own swap, it should be possible to swap 3.25% yen for 5.75% sterling - but that would be more expensive than the straight gilt swaps.

Did the Acted solution go into any more detail other than mentioning gilt swaps?

 

[Meldemon]

i think i got it!

By using standard exchange traded currency futures to construct a swap, the individual company credit rating doesn't come into play - i.e. swap 2% yen for 4.5% gbp and buying 1.28 times the size of contracts (i.e. overall exposure is greater than the original loan). My calculation came out quite close to the 2.5%, based on 1.28 times the investment-to-loan ratio (I missed this crucial bit in my original calc).

If a swap was arranged directly with an investment bank the individual company credit rating would be taken into account and the swap would be 3.25% yen / 5.75% gbp, i.e. only invest the amount borrowed but need to earn a higher % on that investment to service the loan.

To get the marks in the exam your approach would save time to get to the same result, my answer focussed specifically on standardised arrangements - so would be specific to where a question specified that exchange traded contracts should be used...

So we were both right - what do you think?

 

[NeedToQualify]

ACTED solution is to have a swap to make 2% Yen payments and receive 4.5% GBP. The japanese bank borrows at 5.75% GBP.

But this leaves us with exchange rate risk, so it's not useful...

 

[Meldemon]

(also see previous reply) - we can use gilt swaps but would have to base those on a higher level of nominal investment than the actual loan to get to the size of coupon amounts needed for the loan - increased gearing on derivatives exposure = risk (currency? - not sure!).

Alternate would be to follow your approach and arrange individual swap with investment bank to eliminate this problem - guess the answer is that there is more than one solution.

Arranging the swap of 3.25% yen / 5.75% sterling may however not be possible, as an OTC swap counterparty is likely to take account of the company's relative credit ratings in the two currencies in setting its terms. Using gilt swaps is likely to be easier & cheaper to do without the uncertainty (which is probably why Acted took this approach in its answer).

Bringing fees back into the mix, anything that avoids having to get specialist advice from an investment bank would be cheaper unless the bank can provide more favourable terms than the market - unlikely as the company is already experiencing a higher credit margin in Japan.

 

[MartingaleChase]

Misunderstanding of above analysis

Above analysis seem ignore one particular key issue: those percentage numbers is actually Gross Redemption Yield rather than fixed interest payment or coupon rate like those swaps we are familiar with.

It is NOT to a swap where you make 2% Yen payments and receive 4.5% GBP. Both 2% and 4.5% are GRY for two government bonds, they are not fixed interest rates.

Therefore, any conclusion based on this misunderstanding is clearly incorrect.

It is not a swap in the common sense that is designed to provide perfect or accurate matching of each cashflow (interest and principal) to leave the investor no exposure to currency risk.

Rather, the function of this swap works more close to immunisation, but against exchange rate not interest rate. That is to say, it is only aiming to hedge the Present Value (or equally final value) of all cashflows against lower than expected depreciation of sterling.

 

[Meldemon]

Isn't currency hedging part of the point of the question and the proposed solution of using a currency swap. The flat yield curves allows us to assume that we are dealing with fixed rates as fixed = floating at all durations.