The Federal Government’s Use of Interest Rate Swaps and Currency Swaps John Kiff, Uri Ron, and Shafiq Ebrahim, Financial Markets Department • Interest rate swaps and currency swaps are swap agreement is a contract in which contracts in which counterparties agree to two counterparties arrange to exchange exchange cash flows according to a pre-arranged cash-flow streams over a period of time A according to a pre-arranged formula. Two formula. In its capacity as fiscal agent for the federal government, the Bank of Canada has of the most common swap agreements are interest rate carried out swap agreements since fiscal year swaps and currency swaps. In an interest rate swap, counterparties exchange a series of interest payments 1984/85. denominated in the same currency; in a currency • The government uses these swap agreements to swap, counterparties exchange a series of interest pay- obtain cost-effective financing, to fund its foreign ments denominated in different currencies. There is exchange reserves, and to permit flexibility in no exchange of principal in an interest rate swap, but a managing its liabilities. principal payment is exchanged at the beginning and • To minimize its exposure to counterparty credit upon maturity of a currency-swap agreement. risk, the government applies strict credit-rating The swaps market originated in the late 1970s, when criteria and conservative exposure limits based on simultaneous loans were arranged between British a methodology developed by the Bank for and U.S. entities to bypass regulatory barriers on the International Settlements. movement of foreign currency. The first-known foreign currency swap transaction was between the World • Between fiscal 1987/88 and 1994/95, the Bank and IBM in August 1981 and was arranged by government used domestic interest rate swaps to Salomon Brothers (Das 1994, 14–36). This landmark convert fixed-rate debt into floating-rate debt. transaction paved the way for the development of a Currently, the government uses interest rate market that has grown from a negligible volume in the swaps and currency swaps to convert its early 1980s to a notional principal outstanding of Canadian-dollar-denominated debt into foreign US$46.380 trillion at the end of 1999 (Bank for Interna- 1 currency liabilities and to exchange foreign tional Settlements 2000). Currently, the swaps market currency, fixed-rate issues into foreign currency, offers a broad range of financing instruments, liquid floating-rate debt. swaps in most currencies, and a wide spectrum of well-established portfolio-management applications. • The government’s swap program is cost-effective. The Government of Canada has been using interest The estimated past and projected savings on rate swaps to help manage its foreign currency liabilities transactions undertaken since 1988 for which since fiscal 1984/852 and its Canadian-dollar liabilities there are reliable cost comparisons amount to over $500 million. 1. The US$46.380 trillion 1999 year-end total consisted of US$43.936 trillion in interest rate swaps and US$2.444 trillion in currency swaps. 2. A fiscal year is the time between yearly settlement of financial accounts. The fiscal year of the Canadian government ends on 31 March. BANK OF CANADA REVIEW • WINTER 2000–2001 23 since 1987/88.3 These transactions were designed to used instead, the swaps market offers several advan- help the government obtain floating-rate funding4 at tages. First, swap agreements are undertaken pri- more attractive rates than by issuing short-term, fixed- vately, while transactions using exchange-traded income securities. Similarly, the government has used derivatives are public. Second, since swap products currency swaps to provide low-cost, indirect foreign are not standardized, counterparties can customize currency funding to help manage its foreign currency cash-flow streams to suit their requirements. liabilities since 1984/85 and its Canadian-dollar liabil- The swaps market does have limitations, however. ities since 1994/95. At the end of 1999/00, the The privacy of swap agreements exposes counterpar- notional value of the government’s swap portfolio ties to the risk of default, since there are no explicit stood at Can$23.5 billion. performance guarantees on contracts, such as those provided through the clearing houses of futures and options exchanges. It is difficult to alter or terminate a swap agreement after its inception, and it can be diffi- The swaps market offers a broad cult to find a counterparty willing to take the opposite range of financing instruments, side of a specific transaction. The latter limitation has liquid swaps in most currencies, and been alleviated in recent years as the number of swap 5 a wide spectrum of well-established facilitators has increased. portfolio-management applications. In a typical interest rate swap, one counterparty agrees to exchange a fixed rate of interest on a specific notional principal in return for a floating rate of inter- est on the same notional principal. The arrangement also stipulates the term to maturity of the agreement. This article describes the characteristics of swap agree- No principal is exchanged in this transaction. The ments and the motivation behind the federal govern- interest rate on the floating leg of the swap transaction ment’s use of these transactions. The valuation of is typically reset at the beginning of each interest-pay- swap agreements and the government’s management ment period, and the cash interest payment is made at of credit-risk exposure are also examined, together the end of the period. The London Interbank Offered with the manner in which swap transactions are under- Rate, or LIBOR, is commonly used as the floating rate.6 taken to satisfy the government’s various objectives. Payments between counterparties are usually netted, Finally, the article illustrates the cost-effectiveness of and a single amount is settled on each payment date. the federal government’s use of swap agreements. Figure 1 illustrates an interest rate swap. In this exam- ple, counterparty A pays counterparty B the floating Characteristic Features of Swap rate, and B pays A the fixed rate over the term of the Agreements swap agreement. Swap agreements are used to manage risk in financial A currency swap is a contract between two or more markets, to exploit opportunities for arbitrage in capi- counterparties to exchange streams of payments tal markets, and to avoid adverse market conditions or regulations. Swaps are also used in asset/liability Figure 1 management to obtain cost-effective financing and to The Structure of an Interest Rate Swap generate higher risk-adjusted returns (Kolb 1999, 608–47). Although exchange-traded derivatives, such Interest payment at a floating rate as interest rate and foreign currency futures, could be Counterparty Counterparty A B Interest payment at a fixed rate 3. This article extends Thibault’s (1993) study of the role of interest rate swaps in managing Canada’s debt. The swaps discussed here should not be confused with Exchange Fund Account swaps, which are used to manage the government’s day-to-day Canadian-dollar cash balances. For more informa- tion on Exchange Fund Account swaps, see Nowlan (1992). Also, not dis- 5. Swap facilitators are firms that assist in the completion of swap transac- cussed in this article are the Bank of Canada’s foreign currency swap facilities tions, through informational intermediation, market making, and by serving with other central banks (see Bank of Canada 2000, 57). as counterparties. 4. The government defines “floating-rate” funding as debt that matures 6. LIBOR is the interest rate offered by a specific group of London banks for within one year, or that matures beyond one year but has a variable interest deposits in the Eurocurrency market with maturities that range from one rate (Finance Canada 2000, 14-15). month to one year. 24 BANK OF CANADA REVIEW • WINTER 2000–2001 denominated in different currencies, with each stream management of the government’s liabilities and to calculated using a different interest rate. When a typi- obtain cost-effective Canadian-dollar and foreign cur- cal currency swap is initiated, one party exchanges the rency financing. Between 1987/88 and 1994/95, inter- principal in one currency for an equivalent amount est rate swaps were used extensively to convert fixed- denominated in another currency. The principal is rate Canadian securities into floating-rate liabilities converted to the other currency using the then-current under the domestic interest rate swap program. The spot exchange rate. Each counterparty makes interest government currently uses swap agreements in two payments on the principal received at each settlement ways. First, under the domestic currency-swap pro- date over the life of the swap. These payments are not gram, the government converts issues denominated netted. At the end of the swap agreement, principal in Canadian dollars into foreign currency liabilities. payments are exchanged using the spot exchange rate Second, by using foreign interest rate and currency that prevailed when the contract was initiated. The swaps, the government exchanges various foreign most common type of currency swap involves an currency, fixed-rate issues into foreign currency, floating- exchange of interest payments at a fixed rate in one rate liabilities. The domestic currency-swap program currency for floating LIBOR payments in U.S. dollars. began in 1995, and the foreign interest rate and Figure 2 illustrates this type of currency swap. In this currency-swap programs began in 1985. example, counterparty A pays counterparty B the floating rate in U.S. dollars, and A receives from B the other foreign currency fixed rate over the term of the swap agreement. At the inception of the agreement, B The Bank of Canada undertakes pays A the principal in U.S. dollars, while A pays B swaps to allow flexibility in its the principal in the other foreign currency.