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Some of you had emergency reasons & wound not be able to make it => expect an email from me.
Swaps
(or parts of chapter 14)
Agenda
Interest rate risk?
Refinancing
Forward Rate Agreement
Interest Rate Future
Interest Rate Swap
Currency Swap (& how to undo them)
Counterparty Risk
Reference rate
rate of interest used in standardized quotation, loan
Year 1
Year 2
Year 3
5%
5%
1.50%
6.5%
5%
1.50%
6.5%
5%
1.50%
6.5%
Year 0
Year 1
($500,000)
(150,000)
($650,000)
Year 2
($500,000)
(150,000)
($650,000)
$9,850,000
$9,850,000
Year 0
($650,000)
Year 3
($500,000)
(150,000)
($650,000)
($10,000,000)
($650,000) ($10,650,000)
7.07%
All-in-Cost
A-I-C
7.07%
7.57%
6.58%
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%!
Exchange-traded
Exposure Action
Interest
Rate
Outcome
Paying
interest
Short
future
Rates up
Rates down
Earning
interest
Long
future
Rates up
Rates down
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.
Interest rate swap cash flows: interest rates applied to a notional principal, but no
principal is swapped!
Position
Expectation
Strategy
Fixed-Rate Debt
Rates up
Rates down
Stay put
Pay floating/Receive Fixed
The swap does not replace the original loan, must still make payments
at original rates!
Variability
Year 1
Year 2
Year 3
LIBOR
Spread
Total
Floating
Fixed
-5.00%
-1.50%
-6.50%
-5.00%
-1.50%
-6.50%
-5.00%
-1.50%
-6.50%
Variability
Fixed
Floating
Year 1
-5.75%
5.00%
Year 2
-5.75%
5.00%
Year 3
-5.75%
5.00%
Variability
LIBOR (yr. 1) LIBOR(yr. 2) LIBOR (yr. 3)
Paying
-5.00%
-5.00%
-5.00%
Paying
-1.50%
-1.50%
-1.50%
Paying
-5.75%
-5.75%
-5.75%
Receiving
5.00%
5.00%
5.00%
Net Payment
-7.25%
-7.25%
-7.25%
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
Currency Swap
Unwinding Swaps
Can unwind a swap if viewpoints changes
Assume 3-year contract w/ Swiss buyer terminates in
one year
How to unwind it?
Unwinding Swaps
(1.020)
(1.020)
SF15,002,912
$556,000 $10,556,000
PV(US$)
$10,011,078
1
2
(1.055)
(1.055)
Sfr15,002,912
Settlement $10,011,07 8
($229,818)
Sfr1.4650/$
Counterparty Risk
Potential exposure any firm bears that second party to
financial contract will be unable to fulfill obligations.
C$300
million
(Canada)
$260
million
Borrows $390 m
@ US Treasury + 48 b.p.
$130
million
C$150
million
(Finland)
Inter-American
Development Bank
Things to remember
Refinancing
Forward Rate Agreement
Interest Rate Future
Interest Rate Swap
Currency Swap (& how to undo them)
Counterparty Risk.