Admin News

1. Admin News • Final’s date: 60% liked 12/18 (Registrar-set date) . • => So, final will be 12/18. • Some of you had emergency reasons & wound not be able to make it => expect an email from me. • Quiz V next Tuesday… • If absolutely can’t come, please let me know… • Will try to accommodate you . • Otherwise, weight goes to final

2. Swaps (or parts of chapter 14)

3. Agenda • Interest rate risk? • Credit & Repricing risks • What hedging strategy? • Refinancing • Forward Rate Agreement • Interest Rate Future • Interest Rate Swap • Currency Swap (& how to undo them) • Counterparty Risk • Cross Currency Swaps (again )

4. Interest Rate Risk • Fact: all firms sensitive to interest rate changes. • MNE: differing currencies have differing interest rates => interest rate risk larger! • Reference rate • rate of interest used in standardized quotation, loan agreement, or financial derivative valuation • Most common: LIBOR (London Interbank Offered Rate).

5. Credit and Repricing Risk • Credit (roll-over) Risk: risk of change of borrower creditworthiness when renewing credit. • Repricing risk:risk of changes in interest rates charged (earned) when financial contract rate is reset. • For Example: three debt strategies • #1: Borrow $1 million for 3 years @ fixed rate. • #2: Borrow $1 million for 3 years @ floating rate, LIBOR + 2% reset annually. • #3: Borrow $1 million for 1 year @ fixed rate, renew credit annually

6. How to hedge floating-rate loans risk? • Assume floating-rate loan for US$10 m. • Serviced w/ annual payments • Bullet principal payment @ end third year • Loan priced @ US$ LIBOR + 1.50%. • LIBOR reset annually. • At time 0, up-front fee of 1.50%. • Do we know the actually cost?

7. Floating-Rate Loan: Example

8. How to manage a floating rate loan? • Alternatives • Refinancing –refinance the entire agreement. • Forward Rate Agreement (FRA) –lock in future interest rate payment (as w/ forex forward contracts). • Interest Rate Futures • Interest Rate Swaps –Could swap floating rate note for fixed rate note w/ swap dealer.

9. Forward Rate Agreement (FRA) • Interbank-traded contract to buy or sell interest rate payments on notional principal. • E.g.: If you wish to lock in first payment, buy a FRA which locks total interest payment @ 6.5% • If LIBOR above 5%=> receive cash payment from FRA seller reducing LIBOR payment to 5% • If LIBOR below 5% => pay FRA seller cash amount increasing LIBOR payment to 5% • So you locking in payment of 5%+1.5%!

10. Interest Rate Futures • Very often used (unlike forex futures) • high liquidity of interest rate futures markets • standardized interest rate exposures firms • Exchange-traded • Chicago Mercantile Exchange (CME). • Chicago Board of Trade (CBOT). • London Intl Financial Futures & Options Exchange (LIFFE). • Yield calculated from settlement price

11. Eurodollar Futures (3 month), 11/19/03 Source: WSJ, 11/20/03

12. Interest Rate & Currency Swaps • Contractual agreements to exchange (swap) series of cash flows. • Commits each counterparty to exchange amount of funds, @ regular intervals, until expiration. • Interest rate swap: agreement to swap fixed interest payment for floating rate payment. • Currency swap: agreement to swap currencies of debt service => initial currency exchange & reverse @ maturity. • Swap may combine elements of both interest rate and currency swap. • Swap itself not source of capital!

13. Interest Rate Swaps Strategies • Swap = collection of forward contracts for exchange of funds @specified maturities. • reduces transaction costs. • legal structure of swap transaction reduce counterparty risk. • Interest rate swap cash flows: interest rates applied to a notional principal, but no principal is swapped!

14. Example: swapping to fixed rates • Expect rates will rise over life of loan. • => interest rate swap pay fixed/receive floating would be best. • Bank quotes you 5.75% against LIBOR • The swap does not replace the original loan, must still make payments at original rates! • Swap only supplements the loan payments!

15. Interest Rate Swap

16. Currency Swap • So far, raised $10m in floating rate financing & swap into fixed rate payments. • But, may prefer to make debt-service payments in SF. • => would enter into a 3-year pay Swiss francs & receive US$ swap • Both interest rates fixed. • Will pay 2.01% (ask rate) fixed SF interest & receive 5.56% (bid rate) fixed US$. • Spot rate on date of agreement establishes notional principal is in target currency • Notional amount of SF 15,000,000. • Commit to payments SF 301,500 (2.01%  SF15,000,000) • The notional amounts part of swap agreement!

17. Currency Swap Source: Financial Times (as quoted by MSE)

18. Swapping US$ to Swiss Francs

19. Unwinding Swaps • Can unwind a swap if viewpoints changes… • Assume 3-year contract w/ Swiss buyer terminates in one year • How to unwind it? • Discount remaining cash flows under swap agreement @ current interest rates. • Convert target currency back to home currency

20. Unwinding Swaps • Assume two payments left: SF301,500 & SF15,301,500 • 2-year fixed rate for SF is 2% • PV swap commitment • PV of remaining cash flows on the $-side of swap is determined using current 2 year fixed dollar rate 5.5% • PV net inflows $10,011,078. • PV net outflows SF 15,002,912. • If current spot SF 1.465/$ net settlement

21. Counterparty Risk • Potential exposure any firm bears that second party to financial contract will be unable to fulfill obligations. • A firm entering into a swap agreement retains the ultimate responsibility for its debt-service. • In event swap counterpart defaults, payments would cease. • The real exposure: not total notional principal, but mark-to-market value of differentials!

22. Province of Ontario (Canada) C$150 million C$300 million $260 million $130 million Borrows $390 m @ US Treasury + 48 b.p. Finish Export Credit (Finland) Inter-American Development Bank Borrows C$300 million @ Canadian Treasury + 47 b.p. Borrows C$150 million @ Canadian Treasury + 44 b.p. 3-way Cross Currency Swap Sometimes firms enter into loan agreements w/ swap already in mind, creating debt issuance coupled w/ swap from inception…

23. Things to remember… • Interest rate risk? • Credit & Repricing risks • What hedging strategy? • Refinancing • Forward Rate Agreement • Interest Rate Future • Interest Rate Swap • Currency Swap (& how to undo them) • Counterparty Risk. • Cross Currency Swaps.