Admin NewsFinals date: 60% liked 12/18 (Registrar-set date) .

=> So, final will be 12/18.

Some of you had emergency reasons & wound not be able to make it => expect an email from me.

Quiz V next Tuesday

If absolutely cant come, please let me know

Will try to accommodate you .

Otherwise, weight goes to final

Swaps

(or parts of chapter 14)

Agenda Interest rate risk?Credit & Repricing risks

What hedging strategy?RefinancingForward Rate AgreementInterest Rate FutureInterest Rate SwapCurrency Swap (& how to undo them)

Counterparty Risk

Cross Currency Swaps (again )

Interest Rate RiskFact: all firms sensitive to interest rate changes.

MNE: differing currencies have differing interest rates => interest rate risk larger!

Reference raterate of interest used in standardized quotation, loan agreement, or financial derivative valuationMost common: LIBOR (London Interbank Offered Rate).

Credit and Repricing RiskCredit (roll-over ) Risk: risk of change of borrower creditworthiness when renewing credit.

Repricing risk: risk of changes in interest rates charged (earned) when financial contract rate is reset.

For Example: three debt strategies#1: Borrow $1 million for 3 years @ fixed rate.#2: Borrow $1 million for 3 years @ floating rate, LIBOR + 2% reset annually.#3: Borrow $1 million for 1 year @ fixed rate, renew credit annually

How to hedge floating-rate loans risk?Assume floating-rate loan for US$10 m.

Serviced w/ annual payments

Bullet principal payment @ end third year

Loan priced @ US$ LIBOR + 1.50%. LIBOR reset annually.At time 0, up-front fee of 1.50%.

Do we know the actually cost?

Floating-Rate Loan: Example

Sheet1

3-year $10,000,000 floating rate loan

Loan Interest RateYear 0Year 1Year 2Year 3

LIBOR5%5%5%5%

Spread1.50%1.50%1.50%

Total6.5%6.5%6.5%

Interest Cash FlowsYear 0Year 1Year 2Year 3

LIBOR($500,000)($500,000)($500,000)

Spread(150,000)(150,000)(150,000)

Total($650,000)($650,000)($650,000)

Loan Proceeds$9,850,000($10,000,000)

Total Loan cash flow$9,850,000($650,000)($650,000)($10,650,000)

IRR of total cash flow7.07%

All-in-Cost

Sensitivity to LIBORA-I-CLIBOR (yr. 0)LIBOR (yr. 1)LIBOR(yr. 2)LIBOR (yr. 3)

Baseline case7.07%5%5%5%5%

LIBOR up 25 bp/year7.57%5%5.25%5.50%5.75%

LIBOR down 25 bp/year6.58%5%4.75%4.50%4.25%

Loan Interest RateVariabilityYear 1Year 2Year 3

LIBORFloating-5.00%-5.00%-5.00%

SpreadFixed-1.50%-1.50%-1.50%

Total-6.50%-6.50%-6.50%

Swap Cash FlowsVariabilityYear 1Year 2Year 3

Pay fixedFixed-5.75%-5.75%-5.75%

Receive floating LIBORFloating5.00%5.00%5.00%

Loan & Swap PositionVariabilityLIBOR (yr. 1)LIBOR(yr. 2)LIBOR (yr. 3)

LIBOR on loanPaying-5.00%-5.00%-5.00%

Spread (fixed)Paying-1.50%-1.50%-1.50%

Pay fixed on swapPaying-5.75%-5.75%-5.75%

Receive floating LIBORReceiving5.00%5.00%5.00%

Net interest due after swapNet Payment-7.25%-7.25%-7.25%

Sheet2

Sheet3

How to manage a floating rate loan?AlternativesRefinancing refinance the entire agreement.

Forward Rate Agreement (FRA) lock in future interest rate payment (as w/ forex forward contracts).

Interest Rate Futures

Interest Rate Swaps Could swap floating rate note for fixed rate note w/ swap dealer.

Forward Rate Agreement (FRA)Interbank-traded contract to buy or sell interest rate payments on notional principal.

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%!

Interest Rate FuturesVery often used (unlike forex futures)high liquidity of interest rate futures marketsstandardized interest rate exposures firmsExchange-tradedChicago Mercantile Exchange (CME).Chicago Board of Trade (CBOT).London Intl Financial Futures & Options Exchange (LIFFE).Yield calculated from settlement price

ExposureActionInterest RateOutcomePaying interestShort futureRates upRates downPfutures down (short: profit)Pfutures up (short: loss)Earning interestLong futureRates upRates downPfutures down (long: loss)Pfutures up (long: profit)

Eurodollar Futures (3 month), 11/19/03Source: WSJ, 11/20/03

Interest Rate & Currency SwapsContractual agreements to exchange (swap) series of cash flows.

Commits each counterparty to exchange amount of funds, @ regular intervals, until expiration.

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.

Swap itself not source of capital!

Interest Rate Swaps StrategiesSwap = collection of forward contracts for exchange of funds @specified maturities.reduces transaction costs.legal structure of swap transaction reduce counterparty risk.

Interest rate swap cash flows: interest rates applied to a notional principal, but no principal is swapped!

PositionExpectationStrategyFixed-Rate DebtRates upRates downStay putPay floating/Receive FixedFloating-Rate DebtRates upRates downPay fixed/Receive floatingStay put

Example: swapping to fixed ratesExpect rates will rise over life of loan.

=> interest rate swap pay fixed/receive floating would be best.

Bank quotes you 5.75% against LIBOR

The swap does not replace the original loan, must still make payments at original rates!

Swap only supplements the loan payments!

Interest Rate Swap

Sheet1

Floating Rate Loan Service

Loan Interest RateYear 0Year 1Year 2Year 3

LIBOR

Spread

Total

Interest Cash FlowsYear 0Year 1Year 2Year 3

LIBOR

Spread

Total

Loan Proceeds

Total Loan cash flow

Sensitivity to LIBORLIBOR (yr. 0)LIBOR (yr. 1)LIBOR(yr. 2)LIBOR (yr. 3)

Baseline case

LIBOR up 2pbp/year

LIBOR down 2pbp/year

Loan Interest RateVariabilityYear 1Year 2Year 3

LIBORFloating-5.00%-5.00%-5.00%

SpreadFixed-1.50%-1.50%-1.50%

Total-6.50%-6.50%-6.50%

Swap Cash FlowsVariabilityYear 1Year 2Year 3

Pay fixedFixed-5.75%-5.75%-5.75%

Receive floating LIBORFloating5.00%5.00%5.00%

Loan & Swap PositionVariabilityLIBOR (yr. 1)LIBOR(yr. 2)LIBOR (yr. 3)

LIBOR on loanPaying-5.00%-5.00%-5.00%

Spread (fixed)Paying-1.50%-1.50%-1.50%

Pay fixed on swapPaying-5.75%-5.75%-5.75%

Receive floating LIBORReceiving5.00%5.00%5.00%

Net interest due after swapNet Payment-7.25%-7.25%-7.25%

Sheet2

Sheet3

Currency SwapSo far, raised $10m in floating rate financing & swap into fixed rate payments.But, may prefer to make debt-service payments in SF.=> would enter into a 3-year pay Swiss francs & receive US$ swapBoth interest rates fixed.Will pay 2.01% (ask rate) fixed SF interest & receive 5.56% (bid rate) fixed US$.Spot rate on date of agreement establishes notional principal is in target currencyNotional amount of SF 15,000,000. Commit to payments SF 301,500 (2.01% SF15,000,000)The notional amounts part of swap agreement!

Currency SwapSource: Financial Times (as quoted by MSE)

Swapping US$ to Swiss Francs

Unwinding SwapsCan unwind a swap if viewpoints changesAssume 3-year contract w/ Swiss buyer terminates in one yearHow to unwind it?Discount remaining cash flows under swap agreement @ current interest rates.

Convert target currency back to home currency

Unwinding SwapsAssume two payments left: SF301,500 & SF15,301,500 2-year fixed rate for SF is 2%PV swap commitment

PV of remaining cash flows on the $-side of swap is determined using current 2 year fixed dollar rate 5.5%

PV net inflows $10,011,078.PV net outflows SF 15,002,912.If current spot SF 1.465/$ net settlement

Counterparty RiskPotential exposure any firm bears that second party to financial contract will be unable to fulfill obligations.

A firm entering into a swap agreement retains the ultimate responsibility for its debt-service.

In event swap counterpart defaults, payments would cease.

The real exposure: not total notional principal, but mark-to-market value of differentials!

3-way Cross Currency SwapSometimes firms enter into loan agreements w/ swap already in mind, creating debt issuance coupled w/ swap from inception

Things to rememberInterest rate risk?Credit & Repricing risks

What hedging strategy?RefinancingForward Rate AgreementInterest Rate FutureInterest Rate SwapCurrency Swap (& how to undo them)

Counterparty Risk.

Cross Currency Swaps.