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CHAPTER OVERVIEWCHAPTER OVERVIEW
I.I. Interest Rate and Currency Interest Rate and Currency SwapsSwaps
II.II. Structured NotesStructured Notes
III.III. Interest Rate Forwards and Interest Rate Forwards and FuturesFutures
IV.IV. International LeasingInternational Leasing
V. V. LDC Debt-Equity SwapsLDC Debt-Equity Swaps
I. Interest Rate and Currency I. Interest Rate and Currency SwapsSwaps
I.I. Interest Rate and Currency SwapsInterest Rate and Currency Swaps
A.A. Basic Features:Basic Features:
1.1. Explosive growth in swap Explosive growth in swap marketmarket
2.2. Two types of swaps:Two types of swaps:
- interest rate- interest rate
Interest Rate SwapsInterest Rate Swaps
B.B. Interest Rate SwapsInterest Rate Swaps
1.1. Definition:Definition:
• two-party agreementtwo-party agreement
• to exchange interest paymentsto exchange interest payments
• for a specific maturityfor a specific maturity
• based on a notional principalbased on a notional principal
Interest Rate SwapsInterest Rate Swaps
2.2.Notional principalNotional principal
Definition: the reference amount used to Definition: the reference amount used to calculate swap interest paymentscalculate swap interest payments
Not the amount repaid by either Not the amount repaid by either counterpartycounterparty
Interest Rate SwapsInterest Rate Swaps
C.C. Swap MotivationsSwap Motivations
1.1. Risk-reducing potentialRisk-reducing potential
2.2. Cost savingsCost savings
3.3. Exploit comparative advantages Exploit comparative advantages enjoyed by different borrowers in enjoyed by different borrowers in different financial marketsdifferent financial markets
Interest Rate SwapsInterest Rate Swaps
D.D. Other Interest- Rate Swap Features:Other Interest- Rate Swap Features:
1.1. No principal ever changes handsNo principal ever changes hands
2.2. Maturities:Maturities:
1 - 15 years possible1 - 15 years possible
2 - 10 years typical2 - 10 years typical
Interest Rate SwapsInterest Rate Swaps
3.3. Two Types of Interest-Rate SwapsTwo Types of Interest-Rate Swaps
a.a. Coupon SwapsCoupon Swaps
• one counterparty pays a fixed rateone counterparty pays a fixed rate
• second counterparty pays a floating ratesecond counterparty pays a floating rate
• floating rate resets periodically based on a floating rate resets periodically based on a designated index designated index
Interest Rate SwapsInterest Rate Swaps
3.3. Two Types of Interest-Rate Swaps Two Types of Interest-Rate Swaps (continued)(continued)
b.b. Basis swapBasis swap
two counterparties exchange floating two counterparties exchange floating interest payments based on the difference interest payments based on the difference in reference ratesin reference rates
Interest Rate SwapsInterest Rate Swaps
E.E. The Classic Swap TransactionThe Classic Swap Transaction
- an example- an example
1.1. AssumptionsAssumptions
Counterparty A: BBB-rated creditCounterparty A: BBB-rated credit
Counterparty B: AAA-rated creditCounterparty B: AAA-rated credit
Fixed-Rates AvailableFixed-Rates Available
For A, 8.5% is best possibleFor A, 8.5% is best possible
For B, 7.0% is best possibleFor B, 7.0% is best possible
Interest Rate SwapsInterest Rate Swaps
1. 1. Assumptions (continued)Assumptions (continued)
Floating Rates AvailableFloating Rates Available
For A For A 6-month LIBOR + 0.5%6-month LIBOR + 0.5%
For BFor B 6-month LIBOR6-month LIBOR
Interest Rate SwapsInterest Rate Swaps
E.E. The Classic Swap: Step-by-stepThe Classic Swap: Step-by-step
Step 1: Step 1: A receives a $100 million A receives a $100 million loan at LIBOR+50 pointsloan at LIBOR+50 points
from a syndicate of floating-from a syndicate of floating-
rate lenders (simultaneously)rate lenders (simultaneously)
B issues a $100 million B issues a $100 million bond for 5 years fixed at 7%bond for 5 years fixed at 7%
THE CLASSIC SWAP (PART A)THE CLASSIC SWAP (PART A)
STEP ONE:STEP ONE:
Floating-rateLenders
COUNTERPARTYA
Lend $100 million
5-year with resets
BONDMARKET
COUNTERPARTYB
Issue $100 million @7%for 5 years
Interest Rate SwapsInterest Rate Swaps
Step 2: The Swap Agreement (Part A)Step 2: The Swap Agreement (Part A)A borrows $100 million from A borrows $100 million from BigBank and agrees to pay BigBank and agrees to pay 7.35% for 5 years 7.35% for 5 years (.0735 x $100 million)(.0735 x $100 million)
THE CLASSIC SWAP (PART A)THE CLASSIC SWAP (PART A)
STEP ONE:STEP ONE:
Floating-rateLenders
COUNTERPARTY
A
Lend $100 million
5-year with resets
BIGBANK
$100 Mat 7.35%
Interest Rate SwapsInterest Rate Swaps
In exchange for depositing its In exchange for depositing its
$100 million floating-rate loan $100 million floating-rate loan proceeds with BigBank, the proceeds with BigBank, the Bank agrees to pay Bank agrees to pay Counterparty A at the 6-month Counterparty A at the 6-month LIBOR rate (resets to match LIBOR rate (resets to match
the the original loan resets)original loan resets)
THE CLASSIC SWAP (PART A)THE CLASSIC SWAP (PART A)
STEP ONE:STEP ONE:
Floating-rateLenders
COUNTERPARTY
A
Lend $100 million
5-year with resets
BIGBANK
$100 Mat 7.35%
Depositearns 6-moLIBOR
Interest Rate SwapsInterest Rate Swaps
The results from Part A:The results from Part A:
Counterparty A has effectively borrowed Counterparty A has effectively borrowed
at a fixed rate of 7.35% when otherwise at a fixed rate of 7.35% when otherwise
the best the could have received in the the best the could have received in the
fixed-rate market was 8.5%fixed-rate market was 8.5%
Interest Rate SwapsInterest Rate Swaps
Step 2: The Swap Agreement (Part B)Step 2: The Swap Agreement (Part B)
B borrows from BigBank at the B borrows from BigBank at the 6 6 month LIBOR floating rate for month LIBOR floating rate for 5 5 yearsyears
In exchange for the deposit of In exchange for the deposit of B’s bond proceeds of $100 B’s bond proceeds of $100 million, BigBank agrees to pay million, BigBank agrees to pay
B B at 7.25%at 7.25%
THE CLASSIC SWAP (PART B)THE CLASSIC SWAP (PART B)
STEP TWO:STEP TWO:
Floating-rateLenders
COUNTERPARTY
A BIGBANK
BONDMARKET
COUNTERPARTYB
Borrow at LIBOR
Depositat 7.25%
Interest Rate SwapsInterest Rate Swaps
The Result from Part B:The Result from Part B:
Counterparty B has swapped a fixed-Counterparty B has swapped a fixed-rate loan for a floating-rate loan with an rate loan for a floating-rate loan with an effective cost of LIBOR - .25% when effective cost of LIBOR - .25% when otherwise the best the could have otherwise the best the could have obtained in the floating-rate market was obtained in the floating-rate market was a LIBOR-only loan.a LIBOR-only loan.
Interest Rate SwapsInterest Rate Swaps
Part C: Part C: The Gains to BigBank from the The Gains to BigBank from the SwapsSwaps
BigBank:BigBank:ReceivesReceives 7.35% 7.35% PaysPays (7.25%) (7.25%)ReceivesReceives LIBORLIBORPaysPays (LIBOR) (LIBOR)
NetsNets .01%.01%
Interest Rate SwapsInterest Rate Swaps
Part C: Part C: The Gains to BigBank from the The Gains to BigBank from the Swap (continued)Swap (continued)
BigBank receivesBigBank receives
.001 x the notional principal.001 x the notional principal
($100 million)($100 million)
= $100,000 annually for 5 years= $100,000 annually for 5 years
Interest Rate SwapsInterest Rate Swaps
F.F. Cost SavingsCost Savings
CounterpartyCounterparty NormalNormal SwapSwap NetNet
AA 8.5%8.5% 7.857.85 .65.65
BB LIBORLIBOR L-.25L-.25 .25.25
BigBankBigBank .10.10
Total 1.00Total 1.00
Currency SwapsCurrency Swaps
G.G. Currency SwapsCurrency Swaps
1.1. Definition: Definition:
• an exchange of debt-service obligationsan exchange of debt-service obligations
• denominated in one currency denominated in one currency
• purpose:purpose: for the service on an agreed upon principal for the service on an agreed upon principal
amount of debt denominated in anotheramount of debt denominated in another
Currency SwapsCurrency Swaps
2.2. Motivation for Currency SwapsMotivation for Currency Swaps
a.a. Replaces parallel loanReplaces parallel loan
b.b. Solve two potential problems:Solve two potential problems:
1.) 1.) If no right of offset, defaultIf no right of offset, default
by one party does not by one party does not release the other from release the other from making payments. making payments.
• Swaps have right of offset.Swaps have right of offset.
Currency SwapsCurrency Swaps
2).2). Parallel loans remain on the Parallel loans remain on the balance sheet whereas a balance sheet whereas a currency swap does notcurrency swap does not
Currency SwapsCurrency Swaps
3.3. Difference between interest-rate Difference between interest-rate andand
Currency swaps:Currency swaps:
a.a. Currency swaps have an Currency swaps have an exchange of principal at exchange of principal at predetermined exchange predetermined exchange ratesrates
Interest-Rate and Currency SwapsInterest-Rate and Currency Swaps
H.H. Economic Advantages of SwapsEconomic Advantages of Swaps
1.1. Overcome barriers when they Overcome barriers when they exist to effective arbitrage such exist to effective arbitrage such asas
• legal restrictions on forwardslegal restrictions on forwards
• different perceptions by investors of the different perceptions by investors of the creditworthiness of the two counterpartiescreditworthiness of the two counterparties
• tax differentialstax differentials
Interest-Rate and Currency SwapsInterest-Rate and Currency Swaps
H.H. Economic Advantages of Swaps Economic Advantages of Swaps (continued)(continued)
2.2. They provide long-term They provide long-term financing in foreign currenciesfinancing in foreign currencies
II.II. Structured NotesStructured Notes
II.II. Structured NotesStructured Notes
A.A. Definition:Definition:
interest-bearing securities interest-bearing securities whose interest payments are whose interest payments are
by by a a formulaformula set in advance set in advance
B.B. FormulaFormula
may be tied to a variety of may be tied to a variety of different often complex factorsdifferent often complex factors
Structured NotesStructured Notes
C.C. Purpose of Structured NotesPurpose of Structured Notes
1.1. They allow firms to speculate They allow firms to speculate onon
the direction, range, and the direction, range, and volatility of interest ratesvolatility of interest rates
2.2. They also can be used for They also can be used for hedging purposeshedging purposes
Structured NotesStructured Notes
D. Types of Structured NotesD. Types of Structured Notes
1.1. Inverse floatersInverse floaters
2.2. Step-upsStep-ups
3.3. Step-downsStep-downs
III.III. Interest Rate Forwards and Interest Rate Forwards and FuturesFutures
III.III. Interest Rate Forwards and Interest Rate Forwards and FuturesFutures
A.A. Include:Include:
1. 1. Forward forwardsForward forwards
2.2. Forward rate agreementsForward rate agreements
3.3. Eurodollar futuresEurodollar futures
Interest Rate Forwards and Interest Rate Forwards and FuturesFutures
B.B. Forward ForwardsForward Forwards
1.1. Definition:Definition:
a contract that fixes an interest a contract that fixes an interest rate today on a future loan or rate today on a future loan or
depositdeposit
2. 2. Contract specifiesContract specifies– interest rateinterest rate–principal amountprincipal amount–start and ending dates of future interest start and ending dates of future interest
rate periodrate period
Interest Rate Forwards and Interest Rate Forwards and FuturesFutures
C.C. Forward Rate AgreementsForward Rate Agreements
1.1. Definition:Definition:
a cash-settled, over-the-countera cash-settled, over-the-counter
forward contract that allowsforward contract that allows–a fixed interest rate a fixed interest rate – the rate to be applied in the future on the rate to be applied in the future on
some notional principal amountsome notional principal amount– the parties to exchange interest the parties to exchange interest
paymentspayments
Interest Rate Forwards and Interest Rate Forwards and FuturesFutures
D.D. Eurodollar FuturesEurodollar Futures
1.1. Definition:Definition:
a cash-settled futures contract a cash-settled futures contract on a three-month, $1 million on a three-month, $1 million Eurodollar deposit that pays Eurodollar deposit that pays LIBORLIBOR
2.2. Features are similar to Features are similar to currency currency futuresfutures
IV.IV. International LeasingInternational Leasing
IV.IV. International LeasingInternational Leasing
A.A. PurposesPurposes
1.1. To defer and avoid taxesTo defer and avoid taxes
2.2. To safeguard firm’s To safeguard firm’s
foreign foreign subsidiary assetssubsidiary assets
3.3. To avoid currency To avoid currency
controlscontrols
International LeasingInternational Leasing
B.B. Types of LeasesTypes of Leases
1. Operating Lease (true lease)1. Operating Lease (true lease)• ownership and the use of the ownership and the use of the
asset are separatedasset are separated• agreement covers only part of the agreement covers only part of the
useful life of the assetuseful life of the asset
International LeasingInternational Leasing
B.B. Types of LeasesTypes of Leases
2.2. Financial leaseFinancial lease• extends over most of the economic life extends over most of the economic life
of the assetof the asset• noncancelablenoncancelable• if cancelable, it requires substantial if cancelable, it requires substantial
penalty to the lessorpenalty to the lessor• in effect, lessor borrows money and in effect, lessor borrows money and
then purchases the assetthen purchases the asset
if a financial lease, lessee allowed if a financial lease, lessee allowed tax depreciation for the purchase tax depreciation for the purchase price price tax deduction for the interest factortax deduction for the interest factorlessor not entitled to tax benefitslessor not entitled to tax benefits
International Leasing International Leasing
3.3. Tax FactorsTax Factors
a lease that qualifies as a true lease a lease that qualifies as a true lease for tax purposes is called a tax-for tax purposes is called a tax-oriented lease entitling lessee tooriented lease entitling lessee to
deduct full value of lease paymentsdeduct full value of lease payments
International LeasingInternational Leasing
if a financial lease, lessee allowed if a financial lease, lessee allowed
• tax depreciation for the purchase price tax depreciation for the purchase price
• tax deduction for the interest factortax deduction for the interest factor
• lessor not entitled to tax benefitslessor not entitled to tax benefits
V. V. LDC Debt-Equity SwapsLDC Debt-Equity Swaps
V. V. LDC Debt-Equity SwapsLDC Debt-Equity Swaps
A. A. The LDC Debt-Equity MarketThe LDC Debt-Equity Market
1.1. enables investors to purchase enables investors to purchase the external debt of less-the external debt of less-developed countries (LDC) todeveloped countries (LDC) to
acquire equity or domestic acquire equity or domestic
currency in those same currency in those same marketsmarkets
LDC Debt-Equity SwapsLDC Debt-Equity Swaps
B.B. Types of Debt Swaps and RationaleTypes of Debt Swaps and Rationale
1.1. LDC loans sell at deep LDC loans sell at deep discounts discounts to their face valueto their face value
2.2. Substantial variation can Substantial variation can occur occur across countriesacross countries
LDC Debt-Equity SwapsLDC Debt-Equity Swaps
3.3. Investors buy loans in Investors buy loans in expectation that credit ratings expectation that credit ratings will increasewill increase
4.4. Arbitrage opportunities occur. Arbitrage opportunities occur. The market offers a more The market offers a more favorable exchange rate that favorable exchange rate that
do do official currency markets. official currency markets.