Chapter 21Interest Rate and Foreign Currency SwapsQUESTIONS1. How does an interest rate swap work? In particular, what is the notional principal?Answer: An interest rate swap is an agreement between counterparties that allows an MNC to change the nature of its debt from a fixed interest rate to a floating interest rate or from a floating interest rate to a fixed interest rate. One counterparty to the basic interest rate swap pays a fixed amount of interest on a notional principal to the other counterparty, which in turn is paying the floating interest rate cash flows on the same notional amount to the first counterparty. The term notional indicates the basic principal amount on which the cash flows of the interest rate swap depend. Unlike a currency swap, no exchange of principal is necessary because the principal is an equal amount of the same currency. Usually, only a net interest payment is made depending upon whether the fixed interest rate stated in the swap is higher or lower than the floating interest rate.2. What is a currency swap? Describe the structure of and rationale for its cash flows.Answer: A currency swap is essentially an agreement between two parties to exchange the cash flows of two long-term bonds denominated in different currencies. The parties exchange initial principal amounts in the two currencies that are equivalent in value when evaluated at the spot exchange rate. Simultaneously, the parties agree to pay interest on the currency they initially receive, to receive interest on the currency they initially pay, and to reverse the exchange of principal amounts at a fixed future date.3. What is a credit default swap? What happens in the event of default?Answer: A credit default swap is essentially a bilateral insurance contract between a protection buyer and a protection seller to protect against default on a specific bond or loan issued by a corporation or sovereign .The protection buyer pays semi-annual or annual insurance premiums to the protection seller. In return, when there is a default event, the protection seller transfers value to the protection buyer.Value is transferred either through physical settlement or cash settlement.If there is physical settlement, the protection buyer delivers the defaulted bond to the protection seller who pays the face amount of the referenced bond.If there is cash settlement, the protection seller pays the buyer the difference between the face value of the bond and the value of the defaulted bond.4. Banks quote interest rate and currency swaps using the 6-month LIBOR as a basis for both transactions. How can a bank make money if it does not speculate on movements in either interest rates or exchange rates?Answer: Banks quote the fixed side of the swap with a bid-ask spread. When they pay the fixed-rate side of the swap, they do so at a lower rate than when they receive the fixed-rate side of the swap from their counterparty. Thus, if they are able to balance the transactions, being both a payer of the fixed rate and a receiver of the fixed rate for the same gross amounts, they earn the bid-ask spread. This can be a substantial amount of money. 5. What is the AIC of a bond issue?Answer: The all-in cost of a bond issue is the internal rate of return that equates the present value of all the future interest and principal payments to the net proceeds received by the issuer.6. What is a comparative advantage in borrowing, and how could it arise?Answer: Comparative advantage in borrowing means that the ratio of the borrowing cost in one currency to the borrowing costs in another currency is not the same for two companies. The company with the lower ratio has a comparative advantage in borrowing the numerator currency even though its absolute borrowing costs may be higher than the other companys costs in each currency. Such differences imply that the companies should borrow in the currency in which they have a comparative advantage, and swap into the currency of choice based on other considerations such as foreign exchange risk.Comparative borrowing advantages arise because institutional differences across countries lead to debt pricing that is slightly different, depending on the ultimate holder of the debt and its currency of denomination. Some of these pricing differences are due to the different ways credit risks are analyzed around the world. Essentially, these differences amount to a market inefficiency that can be exploited for profit. The result is that some companies can more easily issue debt in some currencies than in other currencies.7. What is basis point adjustment? Why is it not appropriate simply to add the basis point differential associated with the first currency to the quoted swap rate that the firm will pay?Answer: If a customer wants the financial intermediary to do a currency swap in which the financial inte