JB Investments Holding Ltd (JB) is a multinational company that is committed to a policy of expansion into African countries. JB finances foreign projects with loans obtained in the currency in which project cash flows are received. JB financed an operation in Liberia with a syndicated loan of $20 million. Currently, the loan has three years to maturity. The loan requires semiannual interest payments at a fixed rate of 6.5% per annum, but JB prefers a floating interest rate as the pattern of cash flows from the Liberian project has changed.
The Finance Director talked to the creditors about JB’s preference for a floating interest rate. The creditors have agreed to accept a floating rate of LIBOR plus 200 basis points over the remaining three years of the loan term. However, the Finance Director feels that this rate is rather too high considering JB’s credit rating. She is therefore considering two alternatives for managing the interest rate risk exposure.
Alternative 1: Coupon swap with a bank
Engage in a coupon swap with UT Bank through which JB trades-in its fixed rate interest payments obligation for floating rate interest payments. The table below presents UT Bank’s bid and ask quotes for fixed dollar coupon rates:
Floating rate quotation:
- Floating rates are pegged at 6-month dollar LIBOR plus 100 basis points.
Alternative 2: Coupon swap with another multinational company
Engage in a coupon swap with McEwen Ltd, a multinational company that has a floating rate dollar debt but prefers fixed coupon payments. The interest rate on McEwen’s dollar debt is LIBOR plus 150 basis points but it can borrow fixed rate dollars at 8%. Assume JB can borrow floating rate dollars at LIBOR plus 200 basis points.
Required:
i) Discuss TWO (2) advantages and TWO (2) disadvantages of hedging interest rate risk with interest rate swap. (4 marks)
View Solution
Advantages:
- Leveraging on relative borrowing advantage: Swaps allow companies to mutually benefit from their relative borrowing advantage by each borrowing in markets they can get the best deal and then swapping for the loan type they actually prefer.
- Flexibility and convenience: Swaps are more flexible than other derivatives, particularly futures and options, as they can be arranged in any size, and can be reversed if necessary.
- Lower transaction cost: Cost of arranging a swap is relatively lower, particularly when no intermediary is involved. Besides, it is cheaper to arrange a swap to manage interest rate swap than having to cancel existing loan contract and arranging a new one.
- Suitability for long-term exposures: Unlike other derivatives such as futures and options, swaps a typically designed for managing long-term exposures. Most of the interest rate risks that firms face are long-term in nature and swaps are well-suited for managing exposures of such maturity.
Disadvantages:
- Counterparty risk: Effectiveness of hedging interest rate risk with interest rate swap is limited by the risk that one party will default leaving the other to bear its obligations. This problem can be solved by using an intermediary to enforce compliance with the swap terms. However, this will imply higher transaction cost.
- Inability to take advantage of upside risk: Under interest rate swaps, parties have the obligation and not the right to swap. This means that a party that takes up a fixed rate commitment, will not be able to take advantage of favourable movement in interest rates. This problem can be solved using a swaption instead.
- Lack of liquidity: Swaps are typically not traded in open secondary markets, and that reduces ability and convenience of liquidating a swap contract when the need arises.
ii) Based on the restructuring deal with the creditors and the two interest rate swap alternatives, recommend a hedging strategy for interest payments on the $20 million dollar debt. Support your recommendation with relevant computations. (10 marks)
View Solution
The recommended hedging strategy is the one that presents the lowest net borrowing cost.
Restructure the existing loan
Under this option, the existing fixed rate dollar loan is structured into a floating rate dollar loan at LIBOR + 200 basis point
Borrowing cost = LIBOR + 2%
Hedging alternative 1: Engage in interest rate swap with a swap bank
Under this arrangement, JB will get the opportunity to pay floating rate (what it prefers) at LIBOR + 100 basis points to UT bank (the swap bank) in exchange for a fixed rate payment (what it does not prefer) at the bid fixed rate, 3-year TN rate + 35 basis points. The fixed rate payments from the swap bank will be at the bid rate as in this case the swap bank will be buying a fixed rate from JB.
JB will still honour its fixed rate obligations to the loan syndicate. With the fixed rate payments received from the swap bank however, much of this fixed rate obligation is effectively shifted to the swap bank.
Note: Though the diagram above aids analysis of interest payments amongst the parties involved, it is not a requirement to answering the question. Full credit should be given to a narrative that explains interest flows even without a diagram.
That is if JB hedges the interest rate risk with an interest rate swap with UT bank, its net borrowing cost would be LIBOR + 125 basis points.
Hedging alternative 2: Engage in interest rate swap with another company
Under this arrangement, the entities will swap currency coupons for the type they prefer. That is, JB would pay to McEwen the floating rate coupons it prefers and then receive fixed rate coupons from McEwen. Thus, either entity ends up paying the interest rate type they prefer.
Comment on swap arrangement:
JB would maintain its fixed rate debt, which is at 6.5%; and McEwen keeps its floating rate debt, which is at LIBOR + 1.5%. And under the swap arrangement, JB pays floating rate (LIBOR + 1.5%) to McEwen in exchange for a fixed rate (7%). JB then pays 6.5% out of the fixed interest payment from McEwen to its creditors, and saves 0.5% on the fixed rate side. On the floating rate side, JB pays LIBOR + 1.5% to McEwen instead of LIBOR + 2% to creditors if the loan is restructured, and thus saves another 0.5%.
JB effectively ends up paying a floating rate; gains 1%, which reduces its borrowing cost to LIBOR + 1%
Working:
Take the floating rate that is swapped to be what McEwen could pay under swap (i.e. LIBOR + 1.5%).
Given that the swap gains are shared equally, the fixed rate that would be swapped is calculated as under:
Summary:
Option Net borrowing cost
Restructure existing loan LIBOR + 2%
Interest rate swap with a bank LIBOR + 1.25%
Interest rate swap with another multinational company LIBOR + 1%
Recommended hedging strategy
Hedging with interest rate swap with McEwen Ltd is recommended as it present the lowest net borrowing cost.
JB maintains its fixed rate debt contract with loan syndicate, and engages in a fixed-for-floating interest rate swap with McEwen. Under the swap arrangement, JB pays floating rate coupons at LIBOR + 1.5% to McEwen in exchange for fixed rate coupons at 7%.
JB then pays 6.5% out of the fixed rate coupons it receives from McEwen to the loan syndicate. Thus, JB effectively shifts the risk associated with the fixed interest rate obligation to the counterparty, McEwen.