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## What is a Derivative

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- Hedging Financial Market Exposure
Interest Rate SwapsCross Currency Interest Rate Swaps

**Slide 2:**What is a Derivative??

“A contract or security, whose value is derived from the price or level changes in some other underlying security, index or other instrument.”- Wall Street Journal definition. A separate financial contract which alters one’s exposure to future changes in: interest rates, equity security prices, commodity prices or foreign exchange rates.

Interest Rate Swaps**Slide 4:**Interest Rate Swaps

Floating Rates of Interest: PRIME: “The base rate on corporate loans posted by at least 75% of the nations 30 largest banks.” The PRIME rate is subject to change on a daily basis.

**Slide 5:**Interest Rate Swaps

Floating Rates of Interest: LIBOR: (London Interbank Offered Rate) “British Bankers Association average of interbank offered rates for dollar deposits in the London market based on quotations at 16 major banks.” The LIBOR rate is available for 1, 2, 3, 4, 5, 6 and 12 month maturity’s.

**Slide 6:**Interest Rate Swaps

**Slide 7:**Interest Rate Swaps

**Slide 8:**Interest Rate Swaps

**Slide 9:**Interest Rate Swaps

Libor + 2.00%

**Slide 10:**Interest Rate Swaps

**Slide 11:**Interest Rate Swaps

Swap Details:Notional Amount: $1,000,000Start Date: August 7, 2001Maturity Date: August 7, 2006Amortization: $0 (bullet amortization)ABC Pays: 5.50% Swap Rate, Quarterly, Actual/360ABC Receives: Libor, Quarterly, Actual/360

**Slide 12:**Interest Rate Swaps

**Slide 13:**Interest Rate Swaps

**Slide 14:**Interest Rate Swaps

**Slide 15:**Assess bank market versus corporate bond market/private placement market.
Issue debt in the market which has a “comparative advantage” in terms of spreads, covenants, etc.
Use Swaps and/or Reverse Swaps to implement the Fixed versus Floating strategy.

Interest Rate Swaps

Cross Currency Interest Rate Swaps**Slide 17:**Cross Currency Interest Rate Swaps

ABC has an opportunity to make a direct investment in Europe, utilizing EURO as the currency. The “Investment” may consist of hard assets (real estate/equipment) or an operating company.

**Slide 18:**Cross Currency Interest Rate Swaps

Principal CashflowsInterest Cashflows

**Slide 19:**Cross Currency Interest Rate Swaps

Unfortunately for ABC, it is unable to raise EURO denominated financing from a European bank.

**Slide 20:**Cross Currency Interest Rate Swaps

Principal CashflowsInterest Cashflows Loan Request

**Slide 21:**Cross Currency Interest Rate Swaps

Fortunately for ABC, it does have a strong relationship with a domestic bank that is experienced in delivering international financing solutions. ABC will raise USD financing. ABC will then enter into a Cross Currency Interest Rate Swap.

**Slide 22:**Cross Currency Interest Rate Swaps

The Cross Currency Swap has these primary features: Converts USD into EURO. Utilize EURO to make investment. No foreign exchange risk, as EURO investment cash flows are converted to USD for debt service (P&I) based on a pre-determined, fixed exchange rate.

**Slide 23:**Cross Currency Interest Rate Swaps

Principal CashflowsInterest Cashflows PNC Bank

**Slide 24:**Cross Currency Interest Rate Swaps

Principal CashflowsInterest Cashflows PNC Bank USD Principal

**Slide 25:**Cross Currency Interest Rate Swaps

Principal CashflowsInterest Cashflows PNC Bank USD Principal USD Principal Exchange EURO Principal Exchange

**Slide 26:**Cross Currency Interest Rate Swaps

Principal CashflowsInterest Cashflows EURO Principal PNC Bank USD Principal USD Principal Exchange EURO Principal Exchange

**Slide 27:**Cross Currency Interest Rate Swaps

EURO Principal USD Principal Libor EURO Principal Exchange Principal CashflowsInterest Cashflows EURO Fixed Rate

**Slide 28:**Cross Currency Interest Rate Swaps

EURO Principal USD Principal USD Libor Principal CashflowsInterest Cashflows EURO Fixed Rate

**Slide 29:**Cross Currency Interest Rate Swaps

EURO Principal EURO Fixed Rate USD Principal USD Libor Principal CashflowsInterest Cashflows 12 1 2 3 4 4 5 6 7 8 9 10 11

**Slide 30:**Cross Currency Interest Rate Swaps

Initial principal advances and use of proceeds:1) PNC Bank lends USD to ABC.2) ABC delivers USD to PNC Capital Markets.3) PNC Capital Markets delivers EURO to ABC.4) ABC lends EURO to ABC Euro.Debt Service Payments:5) ABC Euro pays EURO interest to ABC.6) ABC pays EURO Swap Rate to PNC Capital Markets.7) PNC Capital Markets pays USD Libor to ABC.8) ABC pays USD Libor to PNC Bank.Payoff Loan & Terminate Swap:9) ABC retires its EURO Loan from ABC.10) ABC delivers EURO to PNC Capital Markets.11) PNC delivers USD to ABC.12) ABC retires USD loan from PNC Bank.

**Slide 31:**Hedging Financial Market Exposure