Swaps Chapter 7 (all editions) Sections 7.1 and 7.4 only

7.1 Nature of Swaps A swap is an agreement between two companies to exchange cash flows at specified future times according to certain specified rules Calculation of cash flows involves the future value of an interest rate, exchange rate or other market variable Most popular is the plain vanilla swap (fixed-for-floating).

Notional Principal Definition: The amount upon which the interest payments in an interest-rate swap are based; in other words, it is the nominal value used to calculate the cash flows on swaps Notional Principal itself is not exchanged

LIBOR LIBOR, or London Interbank Offer Rate, is the interest rate offered among international banks in London on the eurodollars Eurodollars: U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate.

An Example of a “Plain Vanilla” Interest Rate Swap A 3 year swap initiated on March 5, 2001 between Microsoft and Intel Microsoft agrees to pay to Intel an interest rate of 5% p.a. on a notional principal of $100 million Intel agrees to pay Microsoft the 6-month LIBOR rate on the same notional principal Agreement specifies that payments are to be exchanged every six months and the 5% rate is quoted with semiannual compounding Next slide illustrates cash flows

Millions of Dollars LIBORFLOATINGFIXEDNet DateRateCash Flow Mar.5, % Sept. 5, %+2.10–2.50–0.40 Mar.5, %+2.40–2.50–0.10 Sept. 5, %+2.65– Mar.5, %+2.75– Sept. 5, %+2.80– Mar.5, %+2.95– Cash Flows to Microsoft

Typical Uses of an Interest Rate Swap Converting a liability from –fixed rate to floating rate –floating rate to fixed rate Converting an investment from –fixed rate to floating rate –floating rate to fixed rate

Liability Converting a liability from –floating rate to fixed rate Eg. Microsoft has arranged to borrow $100 million at LIBOR plus 10 basis points (LIBOR %) With a swap, Microsoft: –Pays LIBOR plus 0.1% –Receives LIBOR under the swap agreement –Pays 5% fixed under the swap agreement Net is that Microsoft pays 5.1%

Liability cont’d Converting a liability from –fixed rate to floating rate Eg. Intel has arranged to borrow $100 million at 5.2% fixed With a swap, Intel: –Pays 5.2% –Receives 5% under the swap agreement –Pays LIBOR under the swap agreement Net is that Intel pays LIBOR + 0.2%

Intel and Microsoft Transform a Liability IntelMS LIBOR 5% LIBOR+0.1% 5.2%

Financial Intermediary -usually gets 3 or 4 basis points F.I. LIBOR LIBOR+0.1% 4.985% 5.015% 5.2% IntelMS Microsoft (MS) ends up borrowing at 5.115% and Intel ends up borrowing at LIBOR %

7.4 The Comparative Advantage Argument Swaps originated because of a phenomenon known as comparative advantage. This means that different companies are able to raise capital at different rates in different markets For example, one company may be able to enter into fixed-rate loans at more advantageous rates than another Similarly, a company may enjoy a relationship with the floating rate market, able to raise capital more cheaply than other companies

The Comparative Advantage Argument cont’d US: $10 to produce one gun and $1 to produce one paperweight New Zealand: $15 dollars to produce one gun and $5 to produce one paperweight US has an absolute advantage in the production of both guns and paperweights; however, New Zealand has a comparative advantage in gun production It costs New Zealand three paperweights to produce one gun; it costs the US ten paperweights to produce one gun. US has a comparative advantage in paperweight production because it costs the US 0.1 guns to produce one paperweight while it costs New Zealand 0.3 guns the US should only produce paperweights and New Zealand should only produce guns, assuming they are both willing to trade freely, and they will both come out ahead, getting more goods at a lower cost.

7.4 The Comparative Advantage Argument – swap example AAACorp wants to borrow floating BBBCorp wants to borrow fixed FixedFloating AAACorp10.00%6-month LIBOR % BBBCorp11.20%6-month LIBOR % AAACorp has a comparative advantage in the fixed rate market and borrows at 10.00% BBBCorp has a comparative advantage in the floating rate market and borrows at LIBOR % They enter into a swap to ensure they each borrow in the desired market

The Swap AAA BBB LIBOR LIBOR+1% 9.95% 10% Net effect: AAACorp borrows at LIBOR % BBBCorp borrows at 10.95%

The Swap when a Financial Institution is Involved AAAF.I.BBB 10% LIBOR LIBOR+1% 9.93% 9.97% Net effect: AAACorp borrows at LIBOR % BBBCorp borrows at 10.97% Financial instituation gains 0.04% or 4 basis points

Criticism of the Comparative Advantage Argument Why should the spread between the rates offered to AAACorp and BBBCorp be different in fixed and floating markets? Floating: both corporations have little chance of default in the next 6 months BBBCorp (low credit rating) has a higher probability to default on the five-year fixed rate Therefore, greater spread on the fixed rates than on floating rates

Questions All editions: 7.1, 7.7, 7.9