Swaps chapter 7 all editions sections 7 1 and 7 4 only
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Swaps Chapter 7 (all editions) Sections 7.1 and 7.4 only. 7.1 Nature of Swaps. A swap is an agreement between two companies to exchange cash flows at specified future times according to certain specified rules

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Swaps chapter 7 all editions sections 7 1 and 7 4 only

SwapsChapter 7 (all editions)Sections 7.1 and 7.4 only


7 1 nature of swaps

7.1 Nature of Swaps

  • A swap is an agreement between two companies to exchange cash flows at specified future times according to certain specified rules

  • Calculation of cash flows involves the future value of an interest rate, exchange rate or other market variable

  • Most popular is the plain vanilla swap (fixed-for-floating).


Notional principal

Notional Principal

  • Definition: The amount upon which the interest payments in an interest-rate swap are based; in other words, it is the nominal value used to calculate the cash flows on swaps

  • Notional Principal itself is not exchanged


Libor

LIBOR

  • LIBOR, or London Interbank Offer Rate, is the interest rate offered among international banks in London on the eurodollars

  • Eurodollars: U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks

  • The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate.


An example of a plain vanilla interest rate swap

An Example of a “Plain Vanilla” Interest Rate Swap

  • A 3 year swap initiated on March 5, 2001 between Microsoft and Intel

  • Microsoft agrees to pay to Intel an interest rate of 5% p.a. on a notional principal of $100 million

  • Intel agrees to pay Microsoft the 6-month LIBOR rate on the same notional principal

  • Agreement specifies that payments are to be exchanged every six months and the 5% rate is quoted with semiannual compounding

  • Next slide illustrates cash flows


Cash flows to microsoft

---------Millions of Dollars---------

LIBOR

FLOATING

FIXED

Net

Date

Rate

Cash Flow

Cash Flow

Cash Flow

Mar.5, 2001

4.2%

Sept. 5, 2001

4.8%

+2.10

–2.50

–0.40

Mar.5, 2002

5.3%

+2.40

–2.50

–0.10

Sept. 5, 2002

5.5%

+2.65

–2.50

+0.15

Mar.5, 2003

5.6%

+2.75

–2.50

+0.25

Sept. 5, 2003

5.9%

+2.80

–2.50

+0.30

Mar.5, 2004

6.4%

+2.95

–2.50

+0.45

Cash Flows to Microsoft


Typical uses of an interest rate swap

Converting a liability from

fixed rate to floating rate

floating rate to fixed rate

Converting an investment from

fixed rate to floating rate

floating rate to fixed rate

Typical Uses of anInterest Rate Swap


Liability

Converting a liability from

floating rate to fixed rate

Eg. Microsoft has arranged to borrow $100 million at LIBOR plus 10 basis points (LIBOR + 0.10%)

With a swap, Microsoft:

Pays LIBOR plus 0.1%

Receives LIBOR under the swap agreement

Pays 5% fixed under the swap agreement

Net is that Microsoft pays 5.1%

Liability


Liability cont d

Converting a liability from

fixed rate to floating rate

Eg. Intel has arranged to borrow $100 million at 5.2% fixed

With a swap, Intel:

Pays 5.2%

Receives 5% under the swap agreement

Pays LIBOR under the swap agreement

Net is that Intel pays LIBOR + 0.2%

Liability cont’d


Intel and microsoft transform a liability

Intel and Microsoft Transform a Liability

5%

5.2%

Intel

MS

LIBOR+0.1%

LIBOR


Financial intermediary usually gets 3 or 4 basis points

Financial Intermediary-usually gets 3 or 4 basis points

4.985%

5.015%

5.2%

Intel

F.I.

MS

LIBOR+0.1%

LIBOR

LIBOR

Microsoft (MS) ends up borrowing at 5.115% and Intel ends up borrowing at LIBOR + 0.215%


7 4 the comparative advantage argument

7.4 The Comparative Advantage Argument

  • Swaps originated because of a phenomenon known as comparative advantage.

  • This means that different companies are able to raise capital at different rates in different markets

  • For example, one company may be able to enter into fixed-rate loans at more advantageous rates than another

  • Similarly, a company may enjoy a relationship with the floating rate market, able to raise capital more cheaply than other companies


The comparative advantage argument cont d

The Comparative Advantage Argument cont’d

  • US: $10 to produce one gun and $1 to produce one paperweight

  • New Zealand: $15 dollars to produce one gun and $5 to produce one paperweight

  • US has an absolute advantage in the production of both guns and paperweights; however, New Zealand has a comparative advantage in gun production

  • It costs New Zealand three paperweights to produce one gun; it costs the US ten paperweights to produce one gun.

  • US has a comparative advantage in paperweight production because it costs the US 0.1 guns to produce one paperweight while it costs New Zealand 0.3 guns

  • the US should only produce paperweights and New Zealand should only produce guns, assuming they are both willing to trade freely, and they will both come out ahead, getting more goods at a lower cost.


7 4 the comparative advantage argument swap example

Fixed

Floating

AAACorp

10.00%

6-month LIBOR + 0.30%

BBBCorp

11.20%

6-month LIBOR + 1.00%

7.4 The Comparative Advantage Argument – swap example

  • AAACorp wants to borrow floating

  • BBBCorp wants to borrow fixed

  • AAACorp has a comparative advantage in the fixed rate market and borrows at 10.00%

  • BBBCorp has a comparative advantage in the floating rate market and borrows at LIBOR + 1.00%

  • They enter into a swap to ensure they each borrow in the desired market


The swap

The Swap

9.95%

10%

AAA

BBB

LIBOR+1%

LIBOR

  • Net effect:

  • AAACorp borrows at LIBOR + 0.05%

  • BBBCorp borrows at 10.95%


The swap when a financial institution is involved

The Swap when a Financial Institution is Involved

9.93%

9.97%

10%

AAA

F.I.

BBB

LIBOR+1%

LIBOR

LIBOR

  • Net effect:

  • AAACorp borrows at LIBOR + 0.07%

  • BBBCorp borrows at 10.97%

  • Financial instituation gains 0.04% or 4 basis points


Criticism of the comparative advantage argument

Criticism of the Comparative Advantage Argument

  • Why should the spread between the rates offered to AAACorp and BBBCorp be different in fixed and floating markets?

  • Floating: both corporations have little chance of default in the next 6 months

  • BBBCorp (low credit rating) has a higher probability to default on the five-year fixed rate

  • Therefore, greater spread on the fixed rates than on floating rates


Questions

Questions

  • All editions: 7.1, 7.7, 7.9


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