Past article: Wizardry in swaps- The Greek case

This article appeared in Capital page, The Edge Malaysia, Issue 796, Mar 8-14, 2010

Financial Wizardry in Swaps – the Greek case

By Jasvin Josen

The international news bulletins in the past two weeks have been overflowing with the stories of Greece hiding its true level of national debt. It eventually emerged that the debt was apparently higher than advertised by around USD1billion. The instrument of choice surfaced as cross currency swaps, which were designed specifically to enable Greece to receive huge loans that were technically “off balance sheet” and therefore not necessarily reported.

This article will explain how such a swap could be set up to allow an undisclosed loan to end up on the laps of the Hellenes.

What is a cross currency swap

A swap is simply an agreement between two parties to exchange (or swap) cash flows in the future. The motivation is more often than not to hedge interest rate risk, currency risk or both.

For interest rate risk, the hedger could be a corporate or sovereign issuing a fixed-rate debt (bond with fixed coupons, say 5% p.a.). Changes in interest rates will affect the discounting rates that are used to value the bond in its books. The market value of the bond is simply the total present value of its cashflows. Present value is a cashflow in a particular year divided by its discount rate. For example say the coupon of $100 will be received in Year 2. We have to value this part of the cashflow today in terms of its present value. Assume forward interest rates indicate Year 2 interest rate at 4.0%. The discount rate for Year 2 will hence be 1/(1+ 0.04)2 =0.925 and the present value of the coupon would be $100*0.925=$92.5. The fixed rate bond issuer is exposed to interest rate risk. Observe that as interest rates increase, the discount rate will fall and so will the present value of the bond.

Issuers have the option to issue floating rate bonds (coupons that go up and down with the changes in interest rates) which will counter the changes in discount rates and consequently result in minimal changes to the bond value. However in some cases, the floating rate notes tend to be less appealing to investors. The way out for the fixed rate bond issuer is to then enter into an interest rate swap where the fixed rate coupons can be exchanged with floating rate coupons. Effectively the issuer is issuing a floating rate bond with hardly any interest rate risk.

For currency risk, the corporate or sovereign probably has issued a foreign debt paying coupons in a foreign currency. For instance Greece issued a sovereign bond in USD but needed EUR to pay for its expenses. Greece was exposed to currency risk as it had to exchange Euros into USD to pay the future coupons and the principal at maturity.

Greece could hedge this currency risk by entering into a currency swap to transform the currency of its bond from USD into EUR.

Chart 1 – Currency Swap

In Chart 1 above, Greece simply passes the USD proceeds received from bondholders to the Swap Counterparty (usually a financial institution) in return for EUR proceeds at the prevailing exchange rate. The bond coupons will be paid in USD to bondholders which will come from the swap counterparty. Greece will pay EUR coupons to the swap counterparty. At maturity Greece will pay the USD principal back to the bondholders which will again be switched into EUR with the swap. It is as though Greece has issued a EUR bond.

Valuation of a Cross Currency Swap

Frequently the currency swap is combined with an interest rate swap to form a cross currency swap. Here, floating (or fixed) foreign cashflows could be swapped with fixed (or floating) domestic cashflows. Pricing the swap is basically like valuing two separate bonds with cashflows in opposite directions. In the Greek case above, it would be the present values (PVs) of the USD ‘bond’ and the EUR ‘bond’. The foreign USD PV is converted to EUR by multiplying it with the spot exchange rate.

[PV(USD cashflows) x Spot USD/EUR ] – PV (EUR cashflows)

When a spot exchange rate is used and the fixed coupon rate (swap rate) makes the PV of the swap zero at inception, the swap is an at-market swap. The PVs will subsequently be positive or negative as the swap matures, depending on the interest rate and exchange rate movements. We will see a detail worked out example later.

The Greek Case

We now examine the Greek case to see how Greece managed to get an “off balance sheet” loan using a cross currency swap. The details are gathered from various news sources, and a hypothetical example is then put forward.

A comparison between a normal cross currency swap and the one that Greece transacted is illustrated in Table below:


The currency swap issued in the Greek case was an “off-market” swap. The spot exchange rate was not used to re-denominate the cashflows of the foreign leg at the inception of the swap. This caused the PV not to be zero but significantly positive to Greece. Further, the interest rates payable by Greece to the swap counterparty were deferred to ease the burden in the earlier years. The effect of this was to create an upfront payment by the swap counterparty to Greece at inception. The swap counterparty would recoup these non-standard cashflows at maturity, receiving a large ‘balloon’ cash payment from Greece.

I will illustrate with an example with some numbers.

Chart 2 shows an at-market swap at inception. Column B shows the cashflows (principal and coupons) of the foreign (USD) leg. Column C shows the PV of these cashflows, discounted at the USD rate of 4% assuming a flat term structure of interest rates. In column D we have the EUR (domestic) leg and in column E, the PV of those cashfows discounted at the EUR rate of 3%. The spot (market) exchange rate of [USD1=EUR0.8] is used to value the swap and make the initial notional exchange. The swap rate (effectively the fixed rate on the EUR leg) that would make the PV zero is worked out to be 4.80% (48/1000)

Now, the same swap adopted in the Greek case will look like Chart 3.

Note that the fictional exchange rate of 0.9 instead of 0.833 is used. Coupons were designed to be lighter in the earlier years to provide some breathing space. Instead of having a swap rate to make the PV zero at inception, coupons and exchange rates seem to have been worked backwards to enable the swap to have a positive PV that results in an upfront payment to Greece.

The swaps are said to have been done around 2001 with long maturities of around 15-20 years. Balloon payments outwards close to the maturity of the swap would have very low PVs as discount rates get higher with longer maturities. Big inflows in the beginning (high positive PVs) and big outflows at the end (low negative PVs) will easily give a positive PV for Greece at inception.

The upfront payment was hidden from public view as the amount could be treated as a currency trade rather than a loan. This credit disguised as a swap did not show up in the Greek debt statistics. Eurostat’s reporting rules do not comprehensively record transactions involving derivatives.

Back in 2003, author Nick Dunbar had already smelt danger and highlighted his concern in the Risk Magazine, July 2003. He warned about the loopholes in the Europe reporting rules. Information sources state that only in March 2008 Eurostat changed the rules allowing a debt swapped into another currency using an off-market rate to be regarded as two components – an at-the-market swap and a loan from the swap counterparty – with the latter included in government debt.


Greece seemed to be in a tight spot early of the century. There was pressure to keep national debts low to meet the European Union targets. Around then Greece also hosted the 2004 Olympics which would have incurred huge preparation costs. It is no surprise that some financial wizardry was urgently needed. After all, derivatives are very flexible instruments.

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