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Basis Swaps to Assess Borrowing Opportunities Lab

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Basis Swaps to Assess Borrowing Opportunities Lab Instructions and Guide for Basis Swaps To Assess Borrowing Opportunities Lab FINC413 Lab c 2014 Paul Laux and Huiming Zhang 1 Introduction 1.1 Overview In last lab, you explored the basics of swaps, focusing on two types: single currency plain vanilla interest rate swaps and cross currency basis swaps. From that lab, you have basic knowledge of swap pricing. You also should understand how the market value of the swap change as swap rate, spread, discount curve and so on change over time in the marketplace. In this lab, you will focus on cross currency basis swap, and you will relate the swap spread (i.e., over foreign currency LIBOR) to your other finance knowledge. Think of yourself has being an international corporate with a borrowing need. Infor- mation from the swap market, along with your analysis, will enable you to compare borrowing opportunities among international markets, checking to see if there is a better borrowing deal for your company in one or another currency. You might find your company a comparative borrowing advantage in one of the markets over the others. In addition, you will make comparisons across swap spreads in terms of term structures (term of the deal) and history (what are the trends). This will help you think about the underlying factors, and about what might come next. The main activities in this lab guide are: • Review of swap spread 1 • Analyzing a bar chart view of swap spreads • Analyzing a term structure view of swap spreads • Analysing a historical view of swap spreads • Assess borrowing opportunities by using swap spreads Remember, in this lab, swap spread usually refers to a cross-currency basis swap spread, i.e., the spread over foreign currency LIBOR paid by a counterparty in return for receiving home currency LIBOR. 1.2 Assignment details As you work through these sections, be sure to prepare a detailed logbook for your- self to contain all the steps and results. Your logbook should be in a spiral bound or similar notebook, used only for purposes of our Labs. You will turn in your logbook after each Lab, and it will be returned to you after each Lab is graded. You should make and save screenshots of some of the important Bloomberg screens you construct. (In the lab guide, there are tips for you to save the most important screens and you are expected save the minimum set of screenshots.) In your logbook, record the date/time and description (with the Bloomberg Mnemonic where feasible) of all Bloomberg screens used to obtain the specific numbers you rely on for each question below. This allows for your data to be checked later for the professor's auditing purposes and your review purposes. When you are finished, use your logbook and the understanding you have devel- oped to prepare a 6-8 page Lab Report for turn-in. Your lab report should carefully and professionally explain what you have done, what you have found, and what your work teaches you about finance. Your Lab Report should be numbered and keyed to the sections and specific items in this Lab Guide. Your report should contain some Bloomberg graphics to help illustrate your points and show your completion of the lab items. These should be carefully labelled as numbered exhibits and should be placed in an Appendix at the end of your written report. Every Exhibit should be specifically discussed in the text of your report! Do not attach extra pages and pictures that you do not refer to in the body of your report, by specific exhibit number. 2 You may work through the lab with a partner, and you may turn in a single report for your partner team. Your Lab Report must be typed and carefully edited, and it should conform to professional standards for a business report. A final note, about this Lab Guide. The Guide gives specific instructions on how to do the experiment, which have been tested on a Bloomberg terminal. Sometimes Bloomberg changes functionality, and the defaults and settings on your account may vary from the account used for testing. Thus, some flexibility and small adjustments on your part may be needed as you work through the Lab Guide. 2 Review of swap spread 1. Command line. Type SWPM and <Go> in command line. Top. Click Products red button at the top of the screen,select Cross Currency Swaps in the drop-down list and select Cross Currency Swap (Float-Float) a the pop-up list. You will have a 5 year USD-EUR cross currency basis swap setting. The term of maturity of the swap is 5 year, the Currency in Leg 1 is USD and Currency in Leg 2 is EUR, the Index in Leg 1 is US0003M and Index in Leg 2 is EUR003M. The setting for Reset Freq and Pay Freq should be all Quarterly, Day Count should be ACT/360 and Leverage is 1.00000 for both Leg 1 and Leg 2. In Leg 2, on your right-hand side, at the right top of the screen, Spread indicates the difference between the floating rate the payer is obligated to make and the European forward rate. • What is the Spread comes up on your screen in Leg 2? What does the spread suggest? (Hint: if you are in the zero-market value swap, and you have an US borrowing obligation, what is the underlying interest rate you can borrow in European market?) • The indices used in SWPM (for instance, US 3M Libor), are the base rates used by banks to set their loan interest rates. What is the Latest Index in Leg 1? • What is the Latest Index in Leg 2? 3 • What is the difference between Latest Index in Leg 1 and that in Leg 2? Is the difference the same as the Spread in Leg 2? Why? (Hint: think about the swap pricing formula and notice that both counterparties have the same credit ratings in Bloomberg settings. You do not need to write a long analysis article, but you might write down some of your thoughts and ideas in several short sentences) 3 Bar chart view of swap spread 1. In this section, you will explore and analyze the current and historical cross currency basis swap spread for a single currency in XCCY. The setting will be a 5 Year USD-EUR basis swap spread against the USD Libor rate. Command Line. Type XCCY <Go> in the command line, click on Views on the top red tool bar and select Single-Currency Analysis. Top. Select EUR as the currency to be analyzed in the Currency drop-down list at the top of the chart, check 5 Year as the tenor on the tenor checkboxes on the right of Currency, select USD Libor as the rate against in the Cross Currency Basis Swap Spreads Quoted vs drop-down list. Right Top. In addition, select 5 Year as the Term at the right top of the screen yellow box as the term of maturity of the spreads showed in the right-hand side column, and choose Bid as the price type used in the Side yellow box right above Term setting. Save the • On the screen will come up the overall view of historical 5-year USD-EUR screen basis swap spreads against the USD Libor rate. How much is the spread level today? Is it same as the spread we have calculated in SWPM for the USD-EUR 5 Year cross currency basis swap, considering that the time is a little later? If it is not, why is that? • How much is the spread 1 week ago? What about 1 month, 2 month, 3 month, 6 month and 1 year ago? Briefly describe the trend and answer when is it highest and when is it lowest. 2. In this section, you will explore the swap spreads for a single currency of a variety of terms of maturity. Check the boxes at the top of the screens or 4 1 Year, 3 Year and 10 Year and remain other settings unchanged. You will have the chart of current and historical 1 Year, 3 Year, 5 Year and 10 Year USD-EUR basis swap spreads on the screen. Save the • What trend does the spreads in each group, i.e. in each period of time, screen show? Are these trends the same? What might, in your best guess, cause the difference in the trends? 3. In this section, you will compare the swap spreads for a variety of currencies and terms of maturity. Select Multi-Currency Analysis on the Views drop-down list. On the screen will display the cross currency basis spreads for multiple currencies specified on the right-hand size column. In this item, you should select AUD, CAD, CHF, EUR, GBP, JPY and RUB. Check the boxes at the top of the screen for 1 Year, 3 Year and 10 Year, and you will be access to the chart of multiple terms of maturity swap spreads. Each currency is displayed in an individual group on the screen and terms of maturity are labelled in different colors in the group. Save the • Compare among the currencies and within each currency groups. What screen trend does the swap spreads show? Do the swap spreads for the seven currencies show the same trend? What might, in your best guess, cause the difference in the trends? 4. The swap gives you the information about interest rates in US and in foreign market. In the next two items, you should think about the borrowing oppor- tunities.
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