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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.
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.
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.
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
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
Swap Rate= Net Cash Flow/Notional (5.2%) -2.60% -2.60% -2.60% -2.60% -2.60% -2.60%
INTEL
Period
(6-month)
6-month Floating cash LIBOR flow received (5%) 4.20% 4.80% 5.30% 5.50% 5.60% 5.90%
1 2 3 4 5 6 7
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.
LIBOR + 0.75%
LOAN
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.
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.
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.
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.
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.
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 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.
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.