Swaps_Interest_Rate_Swaps_Currency_Swaps_Chapter_9.ppt

7/27/2019 Swaps_Interest_Rate_Swaps_Currency_Swaps_Chapter_9.ppt

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Swaps


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A

Ill use yourhouse until July

for $4,000/mo.

Ill use yourboat until July

for $3,000/mo.

($4,000 - $3,000)/mo = $1,000/mo

SWAPS: Exchange assets now; returnthem later; in meantime, pay differential rent.

Heres your houseback; thanks for

returning my boat.

Thanks for returningmy house; heres

your boat back.

B A B

A B

1 2


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SWAP

If A has a commodity that does not need, and B

has another commodity that does not need, and they

both need the others commodity, the best solution is to

exchange (swap) these two commodities at a

reasonable price.

SWAP is exchanging things between two parties at a

reasonable price.

A swap is an agreement to exchange cash flows in the

future according to certain rules about when the cash

flows are to be paid and the way in which they are

calculated.


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Interest Rate Swaps / Cross Currency Swaps

Types of foreign currency swaps:

I nterest rate swaps. Cross-currency swaps

In an interest rate swap, two parties agree to exchange

interest payments, one party agrees to make a fixed

interest paymentsand the other agrees to make variable

or f loating interest paymentsover period of time.

Floating rate is reset each period according to a

benchmark such as the London Interbank OfferedRate (LIBOR).

Note that swaps are like a set of forwards contracts.

Each forward in a swap has a different delivery date,

and the same way of computing the forward price.


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Interest Rate Swap

I agree to pay you 5% of $1,500 million each year for the next fiveyears.

You agree to pay me whatever 1-year LIBOR is (times $1,500million) for each of the next five years.

$1,500 million is the notional .

If LIBOR > 5%, you pay me: (LIBOR - 5%) * $1,500 million

If LIBOR < 5%, I pay you: (5% - LIBOR) * $1,500 million


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ABC and XYZ agree to exchange interest rates on the same currency.

ABC has a debt at 5.2% fixed interest rate per year. XYZ has a debt atLIBOR + 0.10%. XYZ will receive LIBOR from ABC and XYZ will pay toABC a fixed rate of 5% on a notional principal of $100 million.

INTEREST RATE SWAP/EXAMPLE


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Key reason for using an Interest Rate Swap

Expectations are the driver for financial decisions and many otherdecisions in life.

Expectations about the future behaviour of interest rates give riseinterest rates swaps.

Example: If you have a fixed interest rate loan and expect interestrates to fall, you are willing to change your interest rate loan fromfixed to loan. The opposite is also true.

But, at the end, as every thing in LIFE (and finance is part of life),

and because future is uncertain, your expectations may prove to befalse or true.

RISK IS PART OF LIFE. TAKE RISKS KNOWING THE DOWNSIDE OFTHEM.


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MICROSOFT

Period(6-month)

L IBOR Floa ting cash

flow

received

(LIBOR)

Fixed cash

flow

paid

(5%)

Debt

Repayment

(LIBOR +

0.1%)

Net cash

f lows

Sw ap Rate=

Net Cash

Flow/Not ional

(5.2%)

1 4.20%2 4.80% 2.10 -2.5 -2.200 -2.6 -2.60%

3 5.30% 2.40 -2.5 -2.500 -2.6 -2.60%

4 5.50% 2.65 -2.5 -2.750 -2.6 -2.60%

5 5.60% 2.75 -2.5 -2.850 -2.6 -2.60%

6 5.90% 2.80 -2.5 -2.900 -2.6 -2.60%

7 2.95 -2.5 -3.050 -2.6 -2.60%

-16.25 -15.60

INTEL

Period(6-month)

6-month

LIBOR

Floating cash

flow

received

(5%)

Fixed cash

flow

paid

(LIBOR)

Debt

Repayment

(5.2%)

Net cash

f lows

Sw ap Rate=

Net Cash

Flow/Not ional

(LIBOR +0.2%)

1 4.20%

2 4.80% 2.5 -2.10 -2.6 -2.20 -2.2%

3 5.30% 2.5 -2.40 -2.6 -2.50 -2.5%

4 5.50% 2.5 -2.65 -2.6 -2.75 -2.8%

5 5.60% 2.5 -2.75 -2.6 -2.85 -2.9%

6 5.90% 2.5 -2.80 -2.6 -2.90 -2.9%

7 2.5 -2.95 -2.6 -3.05 -3.1%

-15.60 -16.25


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Relevant Elements

Notional is fixed at inception and is never exchanged, it is only usedto calculate interest payments.

One party agrees to make are fixed rate of interest applied to thenotional on the futures dates.

Other party agrees to pay floating rate of interest applied to thesame notional.

When floating payment is made, the interest rate is reset to establishthe next floating payment.

INTEREST RATE SWAP/ Relevant Elements


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INTEREST RATE SWAPS / EXAMPLE

Assume A is a firm that has borrowed GBP 100 million from abank and 10 years remains until the maturity of the loan.

Interest payments on the loan are made annually in arrears (atthe end of each year), with the next payment due in one

years time.

The rate of interest is reset at the end of each year and thenew one is the prevailing LIBOR rate plus 75 basis points(0.75%) per year.

A is exposed to rising interest rates, which would increase itsborrowing costs and impact on its profitability and cost ofcapital for valuation purposes.


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A approaches B which deals in swaps and agrees the followingconditions:

Notional GBP 100 million

Fixed rate A pays a fixed rate of 5% per year

Floating rate B pays a floating rate of LIBOR per year

Payments Annually in arrears (at the end of each year)

Maturity 10 years

LIBOR rate LIBOR rate prevailing the end of period prior to next

payment

A

LOAN

B

5%

LIBOR

LIBOR + 0.75%



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A pays to B, 5% of GBP 100 million

B pays to A, LIBOR of GBP 100 million

Payments between A and B are offset, which means A only pays the

difference to B. Libor rate for the first floating payment will be the existing LIBOR on the

start date plus 75 basis points.

Libor rate for the second floating payment will be the existing LIBOR on the

first swap payment plus 75 basis points.

Libor rate for the third payment will be the existing LIBOR on the second

payment plus 75 basis points, and so on.

A

LOAN

B

5%

LIBOR

LIBOR + 0.75%



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A range of possible LIBOR rates are shown above along with As interest

payments on its loan and cash flows from the swap at each possible rate.

Whatever the LIBOR rate, the As net payment is always the same.

By entering into the swap A moved from a floating rate liability to a fixed rate of5.75% per year.

If LIBOR rate rises, A will receive a stream of cash payments from the swap which

will compensate for the increasing cost of borrowing on its loan.

LIBOR on the loan is cancelled out by the LIBOR receipt on the swap. What

remains is the 5% fixed payment on the swap plus the margin of 0.75% on the

loan.

FLOATING RATE/FIXED RATE

NET PAYMENTS FOR "A"

Expected LIBOR + 0.75% Loan Interest Fixed Rate Payment Floating Rate Net Payment

LIBOR rates GBP millions GBP millions Receipt (LIBOR)

LIBOR + 0.75% 5% LIBOR 5.75%

4% 4.75% -4.75 -5.0 4.0 -5.75

5% 5.75% -5.75 -5.0 5.0 -5.75

6% 6.75% -6.75 -5.0 6.0 -5.75

7% 7.75% -7.75 -5.0 7.0 -5.75



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INTEREST RATE SWAPS (1/4)

ABC and XYZ needs to obtain a loan.

ABC prefers a loan in the floating-rate market, whereas XYZ a loan in the

fixed -rate market. Interest rates for ABC and XYZ are shown in the following table:

ABC Corp is less risky than XYZ Corp because it is offered a more favorable

rate of interest in fixed and floating.

Spreadis the difference between interest rates for two different firms.

Note that "spread" between the interest rate paid by ABC and XYZ in the

two markets are not the same.


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XYZ pays 1.2% more than ABC in the fixed-rate market and only 0.4%

more than ABC in the floating-rate market.

Base on the spreads, XYZ has a comparative advantage in the floating

market and ABC has a comparative advantage in the fixed-rate market.

As the spread between fixed-rates is 1.2%, and the spread between

floating-rates is 0.40%, we expect a total gain of 1.2% - 0.40% = 0.8% per

year. And the gain can be equally distributed between ABC and XYZ. Both,

ABC and XYZ expect to pay 0.4% less.


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ABC and XYZ should borrow in the market where they have comparative

advantage.

ABC should borrow in the fixed-rate market, whereas XYZ should borrowin the floating rate market, and then exchange payments to transform a

fixed-rate loan into a floating-rate loan.

The net effect of the swap is the each party expect to pay 0.4% per year

less than it would have paid if they go direct into the market they want to

borrow.


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EXPECTED INTEREST RATES AFTER SWAP

TRANSFORMING A LIABILITY USING SWAPS

Fixed to Floating / Floating to Fixed


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Uses of an Interest Rate Swap

Converting a l iabi l i tyfrom fixed rate to floating rate or fromfloating rate to fixed rate

Converting an assetfrom fixed rate to floating rate or fromfloating rate to fixed rate


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Currency Swaps

A typical case is a firm borrowing in one currency and

wanting to borrow in another.

Also a currency swap can be used to convert a stream

of foreign cash flows. This type of swap would

probably have no exchange of notional principals.

In a currency swap, the parties make either fixed or

variable payments to each other in different currencies.


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Currency Swap

In an interest rate swap the principal is not exchanged.

In a currency swap the principal is usually exchanged at the

beginning and the end of the swaps life.


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An Example of a Currency Swap

An agreement to pay 11% on a sterling principal of10,000,000 & receive 8% on a US$ principal of$15,000,000 every year for 5 years.

This is a fixed-for-fixed currency swap.


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Uses of a Currency Swap

Conversion from a liability in one currencyto a liability in another currency.

Conversion from an investment in onecurrency to an investment in anothercurrency.

Documents

Swaps_Interest_Rate_Swaps_Currency_Swaps_Chapter_9.ppt