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Derivatives

Derivatives. Lecture 13. SWAPS. Birth 1981 Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principal Key points Spread inefficiencies Same notation principal

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Derivatives

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  1. Derivatives Lecture 13

  2. SWAPS Birth 1981 Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principal Key points Spread inefficiencies Same notation principal Only interest exchanged

  3. SWAPS • “Plain Vanilla Swap” - (generic swap) • fixed rate payer • floating rate payer • counterparties • settlement date • trade date • effective date • terms • Swap Gain = fixed spread - floating spread

  4. SWAPS Example (vanilla/annually settled) XYZ ABC fixed rate 10% 11.5% floating rate libor + .25 libor + .50 Q: if libor = 7%, what swap can be made 7 what is the profit (assume $1mil face value loans) A: XYZ borrows $1mil @ 10% fixed ABC borrows $1mil @ 7.5% floating XYZ pays floating @ 7.25% ABC pays fixed @ 10.50%

  5. SWAPS Example - cont Benefit to XYZ Net position floating +7.25 -7.25 0 fixed +10.50 -10.00 +.50 Net gain +.50% Benefit ABC Net Position floating +7.25 - 7.50 -.25 fixed -10.50 + 11.50 +1.00 net gain +.75%

  6. SWAPS Example - cont Settlement date ABC pmt 10.50 x 1mil = 105,000 XYZ pmt 7.25 x 1mil = 72,500 net cash pmt by ABC = 32,500 if libor rises to 9% settlement date ABC pmt 10.50 x 1mil = 105,000 XYZ pmt 9.25 x 1mil = 92,500 net cash pmt by ABC = 12,500

  7. SWAPS • transactions • rarely done direct • banks = middleman • bank profit = part of “swap gain” example - same continued XYZ & ABC go to bank separately XYZ term = SWAP floating @ libor + .25 for fixed @ 10.50 ABC terms = swap floating libor + .25 for fixed 10.75

  8. SWAPS Example - cont settlement date - XYZ Bank pmt 10.50 x 1mil = 105,000 XYZ pmt 7.25 x 1mil = 72,500 net Bank pmt to XYZ = 32,500 settlement date - ABC Bank pmt 7.25 x 1mil = 72,500 ABC pmt 10.75 x 1mil = 107,500 net ABC pmt to bank = 35,000 bank “swap gain” = +35,000 - 32,500 = +2,500

  9. SWAPS Example - cont benefit to XYZ floating 7.25 - 7.25 = 0 fixed 10.50 - 10.00 = +.50 net gain .50 benefit to ABC floating 7.25 - 7.50 = - .25 fixed -10.75 + 11.50 = + .75 net gain .50 benefit to bank floating +7.25 - 7.25 = 0 fixed 10.75 - 10.50 = +.25 net gain +.25 total benefit = 12,500 (same as w/o bank)

  10. Currency Swaps Similar to interest rate swaps Same type loan, just diff currency WHY? example: you have an investment in Japan Project is financed with US bonds You look for SWAP partner so you can emulate holding Japanese bonds Java Yahoo principal Yen loan 11% 12% $ 1 mil $ loan 8% 11.1% or Y120

  11. Currency Swaps example - continued • Java borrows $1mil @ 8% • Yahoo borrows Y120mil @ 12% • Intl. Bank arranges swap • Java swaps 8% $ loan for 10.3% yen loan w/bank • Yahoo swaps 12% yen loan for 10.4% $ loan w/bank total available benefit = (11.1-8) - (12-11) = 2.1%

  12. Currency Swaps example - continued benefit to Java $ loan +8 - 8 = 0 Yen loan +11 - 10.3 = .7 net gain +.7% benefit to Yahoo $ loan 11.1 - 10.4 = +.7 yen loan -12 + 12 = 0 net gain = .7% benefit to bank $ loan +10.4 - 8 = +2.4 yen loan - 12 + 10.3 = -1.7 net gain + .7%

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