SWAPS

Interest Rate Swap Quotations Euro-€ £ Sterling Swiss franc U.S. $ Bid Ask 1 year 2.34 2.37 5.21 5.22 0.92 0.98 3.54 3.57 2 year 2.62 2.65 5.14 5.18 1.23 1.31 3.90 3.94 3 year 2.86 2.89 5.13 5.17 1.50 1.58 4.11 4.13 4 year 3.06 3.09 5.12 1.73 1.81 4.25 4.28 5 year 3.23 3.26 5.11 5.16 1.93 2.01 4.37 4.39 6 year 3.38 3.41 2.10 2.18 4.46 4.50 7 year 3.52 3.55 5.10 5.15 2.25 2.33 4.55 4.58 8 year 3.63 3.66 2.45 4.62 4.66 9 year 3.74 3.77 5.09 4.48 2.56 4.70 4.72 10 year 3.82 3.85 5.08 2.64 4.75 4.79 3.82–3.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving euro LIBOR or it will receive fixed-rate euro payments at 3.85% against receiving euro LIBOR Financial Times March 4, 2005

An Example of an Interest Rate Swap Consider this example of a “plain vanilla” interest rate swap. Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. It would make more sense to for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans. Want to get in floating rate

An Example of an Interest Rate Swap Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + ½ percent. Firm B would prefer to borrow at a fixed rate. Want to get in fixed rate

An Example of an Interest Rate Swap The borrowing opportunities of the two firms are:

An Example of an Interest Rate Swap The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years Swap Bank 10 3/8% LIBOR – 1/8% Bank A

An Example of an Interest Rate Swap ½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. Swap Bank 10 3/8% LIBOR – 1/8% Bank A 10%

An Example of an Interest Rate Swap The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼% Company B

An Example of an Interest Rate Swap ½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Here’s what’s in it for B: Swap Bank 10 ½% They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. LIBOR – ¼% Company B LIBOR + ½% 11.75 10.50 -------- 1.25 0.75 ------ .50

An Example of an Interest Rate Swap ¼% of $10 million = $25,000 per year for 5 years. The swap bank makes money too. Swap Bank 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank A Company B LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼

An Example of an Interest Rate Swap The swap bank makes ¼% Swap Bank 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% Bank A Company B A saves ½% B saves ½%