Finance 300 Financial Markets Lecture 29 © Professor J. Petry, Fall

2 Housekeeping Final Exam: –Thurs, 12/191:30 - 3:3062 KAM, 550 E. Peabody Conflict: –Friday, 12/201:30 – 3:30126 Wohlers Coverage: –Chapter 9: FuturesThrough page 290 and TTD IX-9. –Chapter 10: OptionsThrough page 330 and TTD X-1 7. No breakeven points, only profit-not value-of options. –Chapter 11: SwapsThrough page 351 and TTD XI-3. Format: –Same as earlier exams. 2 hours total. No formula sheet. –30-40 multiple choice questions. Not comprehensive –Questions will be similar in format to class. Up to half conceptual. Office hours: Monday/Tuesday 2-4. WebBoard.

3 Chapter XI - Swaps Swaps are contracts between two parties to trade the cash flows corresponding to different securities without actually exchanging the securities directly. Swaps are used to: –avoid the transactions costs of buying and selling the underlying securities –Obtain a better deal than could be obtained through traditional borrowing or lending –Exchanging fixed interest rates for floating interest rates is the most common usage Notional Amount: Principal amount used to calculate swap payments.

4 The market did not exist prior to It now involves about $40 trillion a year. Banks generally function as the market makers for swaps, and either take one side of the trade themselves or find a counter-party. To the extent that they make markets, their profit is the difference between the bid-ask spread. There is no secondary market to speak of. Swaps are a specialized product tailored to the needs and abilities of specific firms, hence secondary trading is nearly non- existent.

5 Assume the following information: Bank of America is a AAA rated commercial bank and requires $100 million for 10 years, and can borrow at 10.0% in the fixed rate 10 year market, and at the T-bill +.30% in the floating rate six month market. B of A would prefer short-term floating rate borrowing. Hypothetical Resources is a BBB rated industrial corporation and also requires $100 million for 10 years. It can borrow at 11.90% in the 10 year fixed rate bond market, and at T-bill +.80% in the 6 month floating rate market. HR would prefer long-term fixed rate borrowing. Is it possible to have one or both of these companies get better terms than it could on its own by coordinating with the other firm?

6 By each firm focusing on its comparative advantage (as opposed to absolute advantage when one exists), borrowing in that market, and swapping with the other firm, both firms can do better than they would on their own. In which market does Bank of America have an absolute advantage? Comparative advantage? How about Hypothetical Resources?

7 Assume you as an intermediary recognize this, and approach both parties with the following deal. Bank of America, you borrow $100mn at 10% in the fixed rate market, and we’ll make arrangements such that you will pay a net amount based on a floating rate at the T-bill -.30%. Thus as far as Bank of America is concerned it is like borrowing at T-bill -.30%. Hypothetical Resources, you borrow $100mn at T-bill +.80% in the floating rate market, and we’ll make arrangements such that you will pay a net amount based on a fixed rate of 11.30%. As far as HR is concerned, this is like borrowing at 11.30% in the fixed rate market. If we, as the intermediary, can pull this off, then both parties are better off, and both parties are loving us. Now the big question: Can you make any money doing this?

8 We establish a swap agreement. Both parties borrow in the market at their comparative advantage. Bank of America borrows in the fixed market at 10.0%, and Hypothetical Resources borrows in the floating rate market at T- bill +.80%. Bank of America will pay T-bill +.70% to Hypothetical Resources in exchange for Hypothetical resources paying 11.0% to Bank of America. Hypothetical Resources will pay 11.0% to Bank of America in exchange for receiving T-bill +.50% from Bank of America. Notice that only T-bill +.50% makes its way to HR, even though B of A is paying T-bill +.70%; the rest is commission to the intermediary.

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10 Things To Do: XI-1 The Bank of Champaign buys a swap arrangement from the Bank of Urbana on a notional principal of $100 million, with payments every six months for five years. The buyer pays a fixed rate of 9.05% and receives the London Interbank Offer Rate (LIBOR). The seller pays LIBOR and receives 9.0%. A.On the first payment date LIBOR is 6.5%. What is each party’s payment and receipt on this date?

11 Things To Do: XI-2 Busey Bank can borrow money in the ten year bond Market at 10% and in the six month corporate note market at the T-bill rate plus 0.40%. Technology Transfer Inc can borrow in the ten years bond market at 12% and in the six month corporate note market at the T-bill rate plus 1.0%. A.Busey Bank has a advantage of how many points in each market? B.In what market does Busey have a comparative advantage? Set up a swap agreement such that Busey and Tech Transfer Inc. each borrow $1,000,000 in the market where they have the comparative advantage and then execute a swap whereby Tech Transfer pays 11.1% and Busy pays T-bill +.5%. The intermediary takes.1% off the fixed payment (Tech Transfer pays 11.1% and Busey receives 11.0%) payments are made every six months. C.How much of a basis point advantage does each party get from the swap? D.What is the notional principal amount? E.Calculate each party’s payments and receipts (description, percentage and amount) on this date. (Don’t forget to include payments on corporate debt issued and that this is a semi-annual payments.)