IX: Market Innovations 27: Swap Agreements Credit Arbitrage Swap Currency Swap

IX: Market Innovations

27: Swap AgreementsCredit Arbitrage SwapCurrency Swap

Chapter 27: Swap Agreements

Credit Arbitrage Swap

© Oltheten & Waspi 2012

Chapter 27: Swap Agreements © Oltheten & Waspi 2012


SWAP debt payments to get from the market in which you can borrow at the lowest rate to the market in which you want to pay interest.

Need to borrow $10mRating

10 YearBond Rate

6 month Commercial Paper Rate

Bank of America AAA 10.00% T-Bill + 0.30%Hypothetical Resources BBB 11.90% T-Bill + 0.80%




10 YearBond Rate



190 bp 50 bp

Market in which we would rather pay interest

Market in which we would rather pay interest

Market in which BofA has an absolute advantage

Market in which we have a comparative advantage




10 YearBond Rate



190 bp 50 bp

… and swap into a fixed interest payment

… and swap into a variable interest payment

BofA will borrow in the 10yr fixed market …

HR will borrow in the 6 month fixed market …


Borrow

Each company borrows in the market in which it has a comparative advantage.

Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds

-10.00% Borrow $10 million in Commercial Paper

- (TB + 0.80)%


Swap a fixed payment


-10.00 % Borrow $10 million in Commercial Paper

- (TB + 0.80)%

Swap: fixed payment +11.00 % Swap: fixed payment -11.00 %


Swap a variable payment


-10.00 % Borrow $10 million in Commercial Paper

- (TB + 0.80)%

Swap: fixed payment

+11.00 % Swap: fixed payment

-11.00 %

Swap: variable payment

- (TB +0.70)% Swap: variable payment

+(TB + 0.50)%

0.20% to intermediary


Net debt payment


- 10.00 % Borrow $10 million in Commercial Paper

- (TB + 0.80)%

Swap: fixed payment

+ 11.00 % Swap: fixed payment

- 11.00 %


- (TB + 0.70)% Swap: variable payment

+(TB + 0.50)%

NET: - (TB - 0.30)% NET: - 11.30 %

-10.00 + 11.00 – TB - 0.70=- TB + 0.30

= - (TB - 0.30)- TB - 0.80 - 11.00 + TB + 0.50

=- 11.30




10 YearBond Rate



190 bp 50 bp

Net Payment is 11.30%

Net payment is T-Bill – 0.30%

Gain of 0.60%

Gain of 0.60%

Intermediary gets 0.20%

Total Gains from Swap: 140 basis points


Credit Arbitrage SwapNeed to borrow $10m

Rating10 Year

Bond Rate6 month

Commercial Paper RateBank of America AAA 10.00% T-Bill + 0.30%

Hypothetical Resources BBB 11.90% T-Bill + 0.80%Difference: 190 50

Total Gain = 1.40% = 140 basis points


Engineering the Swap Calculate the advantage

140 basis points Distribute the advantage

60 basis points to Bank of America 60 basis points to Hypothetical Resources 20 basis points to the Intermediary

Calculate the swap backwards from the bottom line


Engineering the Swap



- (TB + 0.80)%

NET: - (TB - 0.30)% NET: - 11.30 %

-(TB + 0.30) + 0.60 = - (TB - 0.30) -11.90 + 0.60 = - 11.30





- (TB + 0.80)%

Swap: fixed payment


- 11.00 %

NET: - (TB - 0.30)% NET: - 11.30 %

Set the fixed payment





- (TB + 0.80)%

Swap: fixed payment


- 11.00 %


- (TB + 0.70)% Swap: variable payment

+(TB + 0.50)%

NET: - (TB - 0.30)% NET: - 11.30 %

Calculate the variable payment


Swap: Payment Flow

Bank ofAmerica

T-Bill – 0.30

Long Term Debt M

arketCo

mm

ercia

l Pap

er M

arke

t

HypotheticalResources

11.30%

Intermediary

10.00%

T-Bill + 0.80 %

.20%

T-Bill + 0.50 %

11.00%

$10,000,000 Notional Principal Amount


Swap Payments Suppose the T-Bill rate is

9.0% at the end of 12 months 10.5% at the end of 6 months 12.0% at the end of 18 months


T-Bill Rate: 9.0%

$75,000

Bank ofAmerica

T-Bill – 0.308.7%

Long Term Debt M

arketCo

mm

ercia

l Pap

er M

arke

t


11.30%

Intermediary

10.00%

T-Bill +0.809.80%

.20%

11.00%


T-Bill +0.509.50 %

1.50%


T-Bill Rate: 10.5%

$0

Bank ofAmerica

T-Bill – 0.30

10.2%

Long Term Debt M

arketCo

mm

ercia

l Pap

er M

arke

t


11.30%

Intermediary

10.00%

T-Bill +0.8011.30%

.20%

11.00%


T-Bill +0.5011.00 %


T-Bill Rate: 12.0%

$75,000

Bank ofAmerica

T-Bill – 0.30

11.7%

Long Term Debt M

arketCo

mm

ercia

l Pap

er M

arke

t


11.30%

Intermediary

10.00%

T-Bill +0.8012.80%

.20%

11.00%


T-Bill +0.5012.50 %

1.50%

Chapter 27: Swap Agreements

Currency Swap

© Oltheten & Waspi 2012


Currency Swap

RatingRate in the

USAEuro Rate

BoeingNeeds to borrow €10m

AAA 5.00% 12.60%

AirleaseNeeds to borrow $9m

BBB 7.00% 13.00%

Difference 200 bp 40 bp

Each company has a comparative advantage in the “wrong” currency so we use a swap to put each company in the target currency at a lower rate.


Borrow

Each company borrows in the market in which it has a comparative advantage.

Boeing Airlease

Borrow $9m -5.00% Borrow €10m -13.00%


Swap Principal

Boeing (€10m) Airlease ($9m)

Borrow $9m -5.00% Borrow €10m -13.00%


Neutralize Currency Risk


Borrow $9m -5.00% Borrow €10m -13.00%

Swap: Dollars + $9m * 5.00% Swap: Euros + €10m * 13.00%


Calculate the advantage

Total Advantage: 160 basis pointsBoeing (€10m) Airlease ($9m)

Borrow $9m -5.00% Borrow €10m -13.00%

Take 20 basis points for the Intermediary and distribute the remaining 140 basis points equallyOriginal Euro Rate - 12.60% Original Dollar Rate - 7.00%

Swap advantage + .70% Swap advantage + .70%

Net: - 11.90% Net: - 6.30%


Distribute the advantage


Borrow $9m -5.00% Borrow €10m -13.00%


Net: - €10m * 11.90% Net: - $9m * 6.30%


Calculate the Swap


Borrow $9m -5.00% Borrow €10m -13.00%


Swap: Euros - €10m * 11.90% Swap: Dollars - $9m * 6.30%

Net: - €10m * 11.90% Net: - $9m * 6.30%


Currency Swap We have completely eliminated the foreign

exchange risk for both counterparties by transferring exchange risk completely to the Intermediary


Payment Flow

With no swap

Airlease Euro Debt Market

US D

olla

r Deb

t Mar

ket Boeing Intermediar

y

€10m @13.00%

$9m * 5.00 %$9m * 6.30 %

€10m * 13.00%€10m * 11.90%

$9m * 5.00 %$9m * 7.00 %

€10m @12.60%


Payment Flow

AirleaseBoeing Intermediary

+ 1.3% of $9m

- 1.1% of €10m

Net: 0.20%+ All the exchange risk

$9m * 6.30 %

€10m * 13.00%€10m * 11.90%

$9m * 5.00 %


Intermediary’s Foreign Exchange Risk Every six months the Intermediary

Takes in ½(1.3% of $9m) = $58,500. Pays out ½(1.1% of €10m) = €55,000. Profit:

Π = $58,500 - €55,000 * $ exchange€ .


Intermediary’s ForEx Risk

-$30,000

-$25,000

-$20,000

-$15,000

-$10,000

-$5,000

$0

$5,000

$10,000

$15,000

$0.80 $0.90 $1.00 $1.10 $1.20 $1.30 $1.40 $1.50 $1.60

$1.0636

$1.40

-$24,000

Swap Agreements

Documents

IX: Market Innovations 27: Swap Agreements Credit Arbitrage Swap Currency Swap