Copyright 1999 A.S. Cebenoyan1 C15.0021 Money, Banking, and Financial Markets Professor A. Sinan Cebenoyan NYU-Stern-Finance.

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Copyright 1999 A.S. Cebenoyan1 C Money, Banking, and Financial Markets Professor A. Sinan Cebenoyan NYU-Stern-Finance

Copyright 1999 A.S. Cebenoyan2 Interest-Rate Swap Example (borrowed from Katerina Simons, New England Economic Review, 1989) 3 Parties involved: –A Public Utility (BBB rated) –A Finance Company (AAA rated) –A Bank (AA rated) Starting Positions: –Utility: has low credit rating. Wants to match its LT assets with LT fixed-rate debt. But finds it expensive –Finance Co: has good rating. Can obtain low cost fixed rate debt, but prefers ST or floating to match ST assets.

Copyright 1999 A.S. Cebenoyan3 Bank serves as middleman Borrowing costs before swap (%): Fixed RateFloating Rate Public Utility 10.00LIBOR +.80 Finance Co LIBOR +.30 difference The finance co. enjoys a lower borrowing cost in both markets. But, the public utility faces relatively lower costs in floating rate mkt. It has a comparative advantage of 65 bp ( ). This 65 bp comp. Advantage is the amount of potential savings from the swap.

Copyright 1999 A.S. Cebenoyan4 Public Utility (BBB) Bank (AA) Finance Company (AAA) Pays 9% fixed Pays 8.9% fixd LIBOR Borrows floating LIBOR +.80 Borrows fixed 8.85 % Public Utility pays bank fixed 9% and receives LIBOR. Its Total Borrowing costs are: 9% - LIBOR + ( LIBOR +.80 ) = 9.8%

Copyright 1999 A.S. Cebenoyan5 Finance Company pays Bank LIBOR and receives 8.9% fixed. Its Total borrowing costs are: LIBOR - 8.9% % = LIBOR % In Summary: Public UtilityFinance Company Pays 9%Pays LIBOR -Receives LIBOR-Receives 8.9% Borrows LIBOR +.80Borrows 8.85% 9.8% LIBOR -.05% Cost w/o swap 10.0% LIBOR +.30% SAVINGS.20 %.35%

Copyright 1999 A.S. Cebenoyan6 Total Potential savings from swap were.65%. The bank takes.10 % spread as compensation for the swap. Note: The parties have not exchanged obligations to make principal payments, only to make each other’s interest payments. Hedges may not be perfect This is a simple example to display the mechanics of a swap. It does not go into risks, and exposures to the parties involved. Interest rate movements and credit risks are very important.