On net, the US company has converted its required service payments into floating rates, which it prefers. The bank’s balancing customer might be a lesser-rated Italian company that sells floating rate dollar denominated securities in London but wants to pay fixed interest. In the absence of the swap, the US company might have preferred to borrow at floating rates directly in the US, but it is encouraged to borrow in London because the swap allows it to shave basis points from the deal, and similarly for the Italian company. The funds for the principal of the two loans have to come from somewhere. Whoever would have bought the US company’s potential US bond issue—say a US resident—will now buy its more attractive Eurobond issue, and similarly for the Italian company. Again, there are no net cross-border flows but positive gross flows. Before the advent of interest rate swaps, this gain from trade between the two companies would not have been possible, and the deals would have been directly financed from national sources.
Tesobono Swaps and Repos
The interest rate swaps described above involved exchanging fixed for floating rate yields in a single currency or fixed rate for fixed rate yields in two different currencies for relatively long maturities. Similar deals are made in large volumes for shorter maturities. Here, the tesobono swap will serve as a useful example of such deals.
Tesobono swaps were offshore derivative operations used by Mexican banks as a means -of leveraging tesobono holdings, the notorious treasury bills of the Mexican government indexed to the peso-dollar exchange rate. In a tesobono swap, a Mexican bank received the yield earned on tesobonos and delivered dollar LIBOR plus some additional basis points, multiplied by a notional amount of dollars.
Table 1. Tesobono Renurchase Agreement
The leverage involved in tesobono swaps can be most readily examined by analyzing first the nearly equivalent tesobono repurchase agreement. As an example, consider a New York investment firm that is willing to lend dollars for one year against tesobono collateral through a repo. The firm engages in a repurchase agreement with a Mexican bank to buy tesobonos at some agreed price and to resell them in a year at the original price
plus a dollar interest rate.9 In the example in Table 1, a Mexican bank sells $1 billion of tesobonos to a New York firm for $800 million with an agreement to repurchase the tesobonos in one year for the original price plus the LIBOR plus 1 percent interest. The yield on tesobonos is 8 percent while dollar LIBOR is 5 percent. Effectively, the Mexican bank has financed a $1 billion tesobono position by borrowing $800 million, although official data on tesobono holding will indicate that a foreign address holds the tesobonos. The gain to the Mexican bank is that it pays LIBOR plus 100 to finance tesobonos that may pay the equivalent of LIBOR plus 300.
The gain to the U.S. lender is that it gets to place dollar funds at LIBOR plus 100 against good collateral while it borrows at LIBOR.