IX: Market Innovations 28: Interest Rate Agreements

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Interest Rate Agreements Ceiling The buyer pays a premium and in return is compensated if the interest rate rises above the ceiling. Floor The buyer pays a premium and in return is compensated if the interest rate falls below the floor.

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Ceiling Cemex Inc buys a ceiling from the Citibank The reference rate is LIBOR The ceiling is set at 6% The notional principal amount is $10m The agreement calls for quarterly settlement for 1 year. The agreement is signed January 1, 2007

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Ceiling DateLIBORPayment to Cemex April 1, %$0. July 1, %0.1% x $10m 4 $2,500. October 1, %0.8% x $10m 4 $20,000. January 1, %$0.

Chapter 27: Swap Agreements Ceiling © Oltheten & Waspi 2012

Chapter 27: Swap Agreements Floor © Oltheten & Waspi 2012

Credit Default Swaps IX: Market Innovations

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Total Return Swap Separates Interest rate Risk from Credit Risk Funding Leg = variable Return Leg = fixed interest plus unrealized gain or loss

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Total Return Swap JQ Investor $100,000 6% Discovery 100 Total Return Swap Speculative Hedge LIBOR +0.5%

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Total Return Swap Risk: Interest Rate: LIBOR = 5.5% Credit: Discovery Swap Funding Leg:5.5% + 0.5%:+ $3,000 Return Leg:6%:- $3,000 Unrealized gain:$0 Net Swap Payment:$0

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Total Return Swap Risk: Interest Rate: LIBOR = 5.2% Credit: Discovery Swap Funding Leg:5.2% + 0.5%:+ $2,850 Return Leg:6%:- $3,000 Unrealized gain:- $2,000 Net Swap Payment:- $2,150 JQ pays his gain to the Hedge Fund

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Total Return Swap Risk: Interest Rate: LIBOR = 5.0% Credit: Discovery Yields down, bond prices should go up but Discovery Café Bond reflects credit risk

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Total Return Swap Risk: Interest Rate: LIBOR = 5.0% Credit: Discovery Swap Funding Leg:5.0% + 0.5%:+ $2,750 Return Leg:6%:- $3,000 Unrealized gain:- - $55,000 Net Swap Payment:+ $54,750 Hedge Fund takes on credit risk; JQ is compensated

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Credit Default Swap JQ Investor $100,000 6% Discovery 100 Credit Default Swap Speculative Hedge Fund 0.25% ($250)paid to SHF quarterly Unlike the Total Return Swap SHF pays JQ only upon default.

Pollution Allocation Units IX: Market Innovations

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Natural Resource Economics In production factors of production are used to the point where marginal cost = marginal revenue Economic Allocation Rights add the cost of open access natural resources back into the production function.

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Pollution Rights Sulphur Dioxide Emission Unit allows the emission of 1 ton of SO 2 up to the expiration year. 1 ton SO 2 emitted in 2009 must be paid for with a 2009 SO 2 unit or a banked pre-2009 unit In March of 2010 the EPA issues units based on historical emissions and auctions 2010 and 2017 units

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Pollution Rights The old factory can reduce emissions by spending $500 1 st ton $600 2 nd ton $700 3 rd & 4 th ton The new factory can reduce emissions by spending $200 1 st & 2 nd ton $300 3 rd & 4 th ton 6 tons

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Pollution Rights Congress mandates a reduction of 2 tons by each factory.

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Cost of reducing emissions The old factory $500 1 st ton $600 2 nd ton $700 3 rd & 4 th ton The new factory $200 1 st & 2 nd ton $300 3 rd & 4 th ton $1,100 $400 TOTAL COST: $1,500 4 tons

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Cost of reducing emissions The old factory $500 1 st ton $600 2 nd ton $700 3 rd ton The new factory $200 1 st & 2 nd ton $300 3 rd & 4 th ton Buy 2 extra pollution credits for $400 each TOTAL COST: $1,000 Sell 2 extra pollution credits for $400 each 6 tons 2 tons

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Cost of reducing emissions The old factory $500 1 st ton $600 2 nd ton $700 3 rd ton The new factory $200 1 st & 2 nd ton $300 3 rd & 4 th ton Cost of credits $800 < $1,100 $1,000 +$800=$200 $200 < $400 TOTAL COST: $1,000 < $1,500

Drop Options

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Drop Options Each student entering the College of Business will receive two Drop Options. DROP OPTION Entitles the student to drop one 3 hour course at any time, up to an including the last day of class, without penalty. Expires: May 15, 2014 Registered to: John Q. Student Assumes four years to graduation plus one year buffer zone Can be used by John Q. Student or sold to another student.

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Drop Options Drop Options will trade in the open market.

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Drop Options Joe is a well-motivated student who plans his program of study and follows it. He never uses his drop options. In his final semester he sells his drop options for $300 each.

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Drop Options Susan drops Marketing 306 but sells her other drop option in her senior year for $320.

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Drop Options Sterling Silverspoon III is drops two classes in his freshman year. He needs two more drop options to repeat Finance 300 (twice). He pays $300 for the first and $320 for the second. He drops Corporate Finance once ($320) and Futures and Options once ($330). He drops Financial Engineering once ($300) and decides to take Investments instead.

The End