Interest_Rate_Swaps_Currency_Swaps_Chapter_9.ppt

7/27/2019 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.

Heres your houseback; thanks for

returning my boat.

Thanks for returningmy house; heres

your boat back.

B A B

A B

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Swaps

SWAP is exchanging things between two parties at a

reasonable price.

If A has a commodity that B needs, and B has another

commodity that A needs, they can exchanges exchange (swap)

these two commodities at a reasonable price.

Suppose A is European firm that needs borrowing USD and

B is an USA firm requiring to borrow . A can get better loan

conditions in than B, and B can get better loan conditions in

USD than A. A and B can borrow in their own markets and

then swap the loans.

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

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 f ixed interest

paymentsand the other agrees to make variable or floating

interest paymentsover period of time.

Floating rate is reset each period. London Interbank

Offered Rate (LIBOR) is the benchmark plus a risk

premium.


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Currency Swaps

It is an exchange of currencies.

Example: 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.

In a currency swap, the parties make either fixed or variablepayments to each other in dif ferent cur rencies.

While, 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 theswaps life.

Uses of a cur rency swap: Conversion from a liability in one

currency to a liability in another currency or conversion from an

investment in one currency to an investment in another currency.


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Key reasons for using an Interest Rate Swap

Expectations are the driver for financial decisions and many

other decisions in life. Expectations about the future

behaviour of interest rates give rise interest rates swaps.

If you have a fixed interest rate loan and expect interest rates

to fall, you are willing to swap your interest rate loan from

fixed to loan. The opposite is also true. At the end, your

expectations may prove to be false or true.

Need for HEDGING is the other reason for using swaps.


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Interest Rate Swap: Example No. 1

APM agrees to pay BNZ 5% interest rate on $1,000 million eachyear for the next five years and BNZ agrees to pay APM LIBOR on$1,000 million for each of the next five years. $1,000 million is thenotional .

If LIBOR > 5%, BNZ pays APM: (LIBOR - 5%) * $1,000 million

If LIBOR < 5%, APM pays BNZ: (5% - LIBOR) * $1,000 million


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Relevant Elements

Notional is fixed at inception and is never exchanged, it is only used tocalculate interest payments.

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

Other party agrees to payfloating rate of interestapplied 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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Assume A is a firm that has borrowed GBP 100 million for a 4 yearsterm.

Interest rate is LIBOR rate plus 75 basis points (0.75%) per year.

Interest payments on the loan are made annually in arrears (at the end of

each year).

A is exposed to rising interest rates, which would increase its borrowingcosts and impact on its profitability and cost of capital for valuation

purposes. A approaches B which deals in swaps and agrees the following

conditions to enter int to a SWAP under the following conditions:

Notional GBP 100 million

A pays a fixed rate of 5% per year

B pays a floating rate of LIBOR per year

Maturity 4 years

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By entering into the swap A moved from a floating rate liability to a fixed rate

of 5.75% per year.

If LIBOR rate rises, A will receive LIBOR payments from B. LIBOR on As debt 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.

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

NET EFFECT OF SWAP ON "A" COST OF DEBT

Expected 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 -5.0 4.0 -5.75

5% -5.75 -5.0 5.0 -5.75

6% -6.75 -5.0 6.0 -5.75

7% -7.75 -5.0 7.0 -5.75


A range of possible LIBOR rates are shown below with As interest payments

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

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A and B are two MNCs searching for funds.

A rating agency says that As credit risk is lower than than Bs credit risk.

Based on expectations and needs of hedging, A prefers a floating-rateand B a fixed-rate.

Fixed-rates and floating-rates for A and B are shown below:

If a swap is possible, A will borrow for B at fixed-rate, and B borrow for A ata floating-rate, then A and B will exchange cash flows. A swap is possibleonly if, as result of it, gains or savings are available for A and B.

If A borrow for B at a fixed-rate market, B would save 1%. If B borrow for Aat a floating rate, A would save 2%. If the swap is done, total savings orgains amount to 3%.

MNC Fixed-rate Floating-rate

A 4.00% LIBOR + 2%

B 5.00% LIBOR


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After new market conditions, fixed-rates and floating-rates for A and B

are now as follows:

Again, a swap is possible only if, as result of it, gains or savings areavailable for A and B. If a swap is possible, A will borrow for B at a fixed-rate, and B borrow for A at a floating rate, then A and B will exchange

cash flows.

If A borrow for B at a fixed-rate market, B would save 1%. If B borrow for Aat a floating rate, A will face no savings. If the swap is done, total savingsor gains amount to 1%.


A 4.00% LIBOR

B 5.00% LIBOR


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Now, fixed-rates and floating-rates for A and B are :

Once again, a swap is possible only if, as result of it, gains or savings areavailable for A and B. If a swap is possible, A will borrow for B at a fixed-rate, and B borrow for A at a floating-rate, then A and B will exchangecash flows.

If A borrow for B at a fixed-rate market, B would save 1%. If B borrow forAat a floating rate, A will end up paying 0.25% more. If the swap is done,total savings or gains amount to 0.75% = 1%-0.25%.


A 4.00% LIBOR

B 5.00% LIBOR+0.25%


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INTEREST RATE SWAPS: Example No. 3

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.

Fixed-rate Floating-rate

ABC Corp. 4.00% LIBOR + 0.10%

XYZ Corp. 5.20% LIBOR + 0.50%

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Spreadis the difference between interest rates for two different firms.

Spreadbetween the interest rate paid by ABC and XYZ in the two markets

are not the same.

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

more than ABC in the floating-rate market.




SPREAD 1.20% 0.40%

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Based 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%, ABC and XYZ a total gain of1.2% - 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.

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

advantage. ABC should borrow in the fixed-rate market, whereas XYZ

should borrow in the floating rate market, and then exchange payments to

transform a fixed-rate loan into a floating-rate loan.




SPREAD 1.20% 0.40%

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After the swap each party expects to pay 0.4% less than it would have paid

if they go direct into the market they want to borrow.

Using a Swap to change f ixed to f loat ing / f loating to f ix ed

ABC Corp. XYZ Corp.

Borrowing Rates -4.0% - (LIBOR +0.5%)

Swap Payment ? ?

Swap Receipt ? ?

NET PAYMENT - (LIBOR-0.3%) -4.8%

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Swap payments must allowed each party to achieve expected savings on

interest rates

Using a Swap to change f ixed to f loat ing / f loating to f ix ed

ABC Corp. XYZ Corp.Borrowing Rates -4.0% - (LIBOR +0.5%)

Swap Payment - LIBOR ?

Swap Receipt ? LIBOR

NET PAYMENT - (LIBOR-0.3%) -4.8%

As result of the swap ABC transformed a fixed-rate liability to a

floating- rate liability, and XYZ transform a floating-rate liability to a

fixed-rate liability.

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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

Documents

Interest_Rate_Swaps_Currency_Swaps_Chapter_9.ppt