Admin News

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Admin News

• Finals date 60 liked 12/18 (Registrar-set
  date) .
• gt So, final will be 12/18.
• Some of you had emergency reasons wound not be
  able to make it gt 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

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Swaps (or parts of chapter 14)
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Agenda

• Interest rate risk?
• Credit Repricing risks
• What hedging strategy?
• Refinancing
• Forward Rate Agreement
• Interest Rate Future
• Interest Rate Swap
• Currency Swap ( how to undo them)
• Counterparty Risk
• Cross Currency Swaps (again ?)

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Interest Rate Risk

• Fact all firms sensitive to interest rate
  changes.
• MNE differing currencies have differing interest
  rates gt interest rate risk larger!
• Reference rate
• rate of interest used in standardized quotation,
  loan agreement, or financial derivative valuation
• Most common LIBOR (London Interbank Offered
  Rate).

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Credit and Repricing Risk

• Credit (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 _at_ fixed rate.
• 2 Borrow 1 million for 3 years _at_ floating
  rate, LIBOR 2 reset annually.
• 3 Borrow 1 million for 1 year _at_ fixed rate,
  renew credit annually

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How to hedge floating-rate loans risk?

• Assume floating-rate loan for US10 m.
• Serviced w/ annual payments
• Bullet principal payment _at_ end third year
• Loan priced _at_ US LIBOR 1.50.
• LIBOR reset annually.
• At time 0, up-front fee of 1.50.
• Do we know the actually cost?

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Floating-Rate Loan Example
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How to manage a floating rate loan?

• Alternatives
• Refinancing 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.

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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 _at_ 6.5
• If LIBOR above 5 gt receive cash payment from
  FRA seller reducing LIBOR payment to 5
• If LIBOR below 5 gt pay FRA seller cash amount
  increasing LIBOR payment to 5
• So you locking in payment of 51.5!

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Interest Rate Futures

• Very often used (unlike forex futures)
• high liquidity of interest rate futures markets
• standardized interest rate exposures firms
• Exchange-traded
• Chicago Mercantile Exchange (CME).
• Chicago Board of Trade (CBOT).
• London Intl Financial Futures Options Exchange
  (LIFFE).
• Yield calculated from settlement price

Exposure Action Interest Rate Outcome
Paying interest Short future Rates up Rates down Pfutures down (short profit) Pfutures up (short loss)
Earning interest Long future Rates up Rates down Pfutures down (long loss) Pfutures up (long profit)
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Eurodollar Futures (3 month), 11/19/03
Source WSJ, 11/20/03
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Interest Rate Currency Swaps

• Contractual agreements to exchange (swap) series
  of cash flows.
• Commits each counterparty to exchange amount of
  funds, _at_ 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 gt initial currency exchange
  reverse _at_ maturity.
• Swap may combine elements of both interest rate
  and currency swap.
• Swap itself not source of capital!

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Interest Rate Swaps Strategies

• Swap collection of forward contracts for
  exchange of funds _at_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!

Position Expectation Strategy
Fixed-Rate Debt Rates up Rates down Stay put Pay floating/Receive Fixed
Floating-Rate Debt Rates up Rates down Pay fixed/Receive floating Stay put
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Example swapping to fixed rates

• Expect rates will rise over life of loan.
• gt 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!

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Interest Rate Swap
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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.
• gt would enter into a 3-year pay Swiss francs
  receive US swap
• Both 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 currency
• Notional amount of SF 15,000,000.
• Commit to payments SF 301,500 (2.01 ?
  SF15,000,000)
• The notional amounts part of swap agreement!

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Currency Swap
Source Financial Times (as quoted by MSE)
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Swapping US to Swiss Francs
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Unwinding Swaps

• Can unwind a swap if viewpoints changes
• Assume 3-year contract w/ Swiss buyer terminates
  in one year
• How to unwind it?
• Discount remaining cash flows under swap
  agreement _at_ current interest rates.
• Convert target currency back to home currency

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Unwinding Swaps

• Assume 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

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Counterparty Risk

• Potential 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!

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3-way Cross Currency Swap
Sometimes firms enter into loan agreements w/
swap already in mind, creating debt issuance
coupled w/ swap from inception
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Things to remember

• Interest rate risk?
• Credit Repricing risks
• What hedging strategy?
• Refinancing
• Forward Rate Agreement
• Interest Rate Future
• Interest Rate Swap
• Currency Swap ( how to undo them)
• Counterparty Risk.
• Cross Currency Swaps.