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Swaps

Exchange assets now; return them later; in meantime, pay differential rent.

SWAPS:

1
Ill use your house until July for $4,000/mo.
Ill use your boat until July for $3,000/mo.

2
Heres your house back; thanks for returning my boat. Thanks for returning my house; heres your boat back.

($4,000 - $3,000)/mo = $1,000/mo

SWAP

If A has a commodity that does not need, and B has another commodity that does not need, and they both need the others commodity, the best solution is to exchange (swap) these two commodities at a reasonable price.

SWAP is exchanging things between two parties at a reasonable price.


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.

Interest Rate Swaps / Cross Currency Swaps

Types of foreign currency swaps: Interest rate swaps. Cross-currency swaps In an interest rate swap, two parties agree to exchange interest payments, one party agrees to make a fixed interest payments and the other agrees to make variable or floating interest payments over period of time. Floating rate is reset each period according to a benchmark such as the London Interbank Offered Rate (LIBOR). Note that swaps are like a set of forwards contracts. Each forward in a swap has a different delivery date, and the same way of computing the forward price.

Interest Rate Swap

I agree to pay you 5% of $1,500 million each year for the next five years. You agree to pay me whatever 1-year LIBOR is (times $1,500 million) for each of the next five years. $1,500 million is the notional . If LIBOR > 5%, you pay me: (LIBOR - 5%) * $1,500 million If LIBOR < 5%, I pay you: (5% - LIBOR) * $1,500 million

INTEREST RATE SWAP/EXAMPLE


ABC and XYZ agree to exchange interest rates on the same currency. ABC has a debt at 5.2% fixed interest rate per year. XYZ has a debt at LIBOR + 0.10%. XYZ will receive LIBOR from ABC and XYZ will pay to ABC a fixed rate of 5% on a notional principal of $100 million.

Key reason 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. Example: If you have a fixed interest rate loan and expect interest rates to fall, you are willing to change your interest rate loan from fixed to loan. The opposite is also true. But, at the end, as every thing in LIFE (and finance is part of life), and because future is uncertain, your expectations may prove to be false or true.

RISK IS PART OF LIFE. TAKE RISKS KNOWING THE DOWNSIDE OF THEM.

MICROSOFT
Period
(6-month)

1 2 3 4 5 6 7

LIBOR Floating cash flow received (LIBOR) 4.20% 4.80% 2.10 5.30% 2.40 5.50% 2.65 5.60% 2.75 5.90% 2.80 2.95

Fixed cash flow paid (5%) -2.5 -2.5 -2.5 -2.5 -2.5 -2.5

Debt Repayment (LIBOR + 0.1%) -2.200 -2.500 -2.750 -2.850 -2.900 -3.050 -16.25

Net cash flows

Swap Rate= Net Cash Flow/Notional (5.2%) -2.60% -2.60% -2.60% -2.60% -2.60% -2.60%

-2.6 -2.6 -2.6 -2.6 -2.6 -2.6 -15.60

INTEL
Period
(6-month)

6-month Floating cash LIBOR flow received (5%) 4.20% 4.80% 5.30% 5.50% 5.60% 5.90%

Fixed cash flow paid (LIBOR)

Debt Repayment (5.2%)

Net cash flows

Swap Rate= Net Cash Flow/Notional (LIBOR +0.2%)

1 2 3 4 5 6 7

2.5 2.5 2.5 2.5 2.5 2.5

-2.10 -2.40 -2.65 -2.75 -2.80 -2.95

-2.6 -2.6 -2.6 -2.6 -2.6 -2.6 -15.60

-2.20 -2.50 -2.75 -2.85 -2.90 -3.05 -16.25

-2.2% -2.5% -2.8% -2.9% -2.9% -3.1%

INTEREST RATE SWAP/ Relevant Elements


Relevant Elements
Notional is fixed at inception and is never exchanged, it is only used to calculate interest payments. One party agrees to make are fixed rate of interest applied to the notional on the futures dates. Other party agrees to pay floating rate of interest applied to the same notional. When floating payment is made, the interest rate is reset to establish the next floating payment.

INTEREST RATE SWAPS / EXAMPLE

Assume A is a firm that has borrowed GBP 100 million from a bank and 10 years remains until the maturity of the loan. Interest payments on the loan are made annually in arrears (at the end of each year), with the next payment due in one years time. The rate of interest is reset at the end of each year and the new one is the prevailing LIBOR rate plus 75 basis points (0.75%) per year. A is exposed to rising interest rates, which would increase its borrowing costs and impact on its profitability and cost of capital for valuation purposes.

INTEREST RATE SWAPS / EXAMPLE


A approaches B which deals in swaps and agrees the following conditions:
Notional Fixed rate Floating rate Payments Maturity LIBOR rate GBP 100 million A pays a fixed rate of 5% per year B pays a floating rate of LIBOR per year Annually in arrears (at the end of each year) 10 years LIBOR rate prevailing the end of period prior to next payment 5% A LIBOR B

LIBOR + 0.75%

LOAN

INTEREST RATE SWAPS / EXAMPLE


5% A LIBOR LIBOR + 0.75% B

LOAN

A pays to B, 5% of GBP 100 million B pays to A, LIBOR of GBP 100 million Payments between A and B are offset, which means A only pays the difference to B. Libor rate for the first floating payment will be the existing LIBOR on the start date plus 75 basis points. Libor rate for the second floating payment will be the existing LIBOR on the first swap payment plus 75 basis points. Libor rate for the third payment will be the existing LIBOR on the second payment plus 75 basis points, and so on.

INTEREST RATE SWAPS / EXAMPLE


FLOATING RATE/FIXED RATE NET PAYMENTS FOR "A"
Expected LIBOR rates 4% 5% 6% 7% LIBOR + 0.75% Loan Interest Fixed Rate Payment GBP millions GBP millions LIBOR + 0.75% 5% -4.75 -5.0 -5.75 -5.0 -6.75 -5.0 -7.75 -5.0 Floating Rate Net Payment Receipt (LIBOR) LIBOR 5.75% 4.0 -5.75 5.0 -5.75 6.0 -5.75 7.0 -5.75

4.75% 5.75% 6.75% 7.75%

A range of possible LIBOR rates are shown above along with As interest payments on its loan and cash flows from the swap at each possible rate. Whatever the LIBOR rate, the As net payment is always the same. 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 a stream of cash payments from the swap which will compensate for the increasing cost of borrowing on its loan. LIBOR on the loan 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.

INTEREST RATE SWAPS (1/4)


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. Spread is the difference between interest rates for two different firms. Note that "spread" between the interest rate paid by ABC and XYZ in the two markets are not the same.

INTEREST RATE SWAPS (2/4)

XYZ pays 1.2% more than ABC in the fixed-rate market and only 0.4% more than ABC in the floating-rate market. Base 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%, we expect a total gain of 1.2% - 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.

INTEREST RATE SWAPS (3/4)

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. The net effect of the swap is the each party expect to pay 0.4% per year less than it would have paid if they go direct into the market they want to borrow.

INTEREST RATE SWAPS (4/4)


EXPECTED INTEREST RATES AFTER SWAP

TRANSFORMING A LIABILITY USING SWAPS Fixed to Floating / Floating to Fixed

Uses of an Interest Rate Swap

Converting a liability from fixed rate to floating rate or from floating rate to fixed rate

Converting an asset from fixed rate to floating rate or from floating rate to fixed rate

Currency Swaps

A typical case is a firm borrowing in one currency and wanting to borrow in another.
Also a currency swap can be used to convert a stream of foreign cash flows. This type of swap would probably have no exchange of notional principals.

In a currency swap, the parties make either fixed or variable payments to each other in different currencies.

Currency Swap

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 the swaps life.

An Example of a Currency Swap

An agreement to pay 11% on a sterling principal of 10,000,000 & receive 8% on a US$ principal of $15,000,000 every year for 5 years. This is a fixed-for-fixed currency swap.

Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency. Conversion from an investment in one currency to an investment in another currency.

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