CHAPTER 16 SPECIAL FINANCING VEHICLES

CHAPTER OVERVIEW I.Interest Rate and Currency Swaps II.Structured Notes III.Interest Rate Forwards and Futures IV.International Leasing V. LDC Debt-Equity Swaps

I. Interest Rate and Currency Swaps A.Basic Features: 1.Explosive growth in swap market 2.Two types of swaps: - interest rate

Interest Rate Swaps B.Interest Rate Swaps 1.Definition: two-party agreement two-party agreement to exchange interest payments to exchange interest payments for a specific maturity for a specific maturity based on a notional principal based on a notional principal

Interest Rate Swaps 2.Notional principal Definition: the reference amount used to calculate swap interest payments Not the amount repaid by either counterparty

Interest Rate Swaps C.Swap Motivations 1.Risk-reducing potential 2.Cost savings 3.Exploit comparative advantages enjoyed by different borrowers in different financial markets

Interest Rate Swaps D.Other Interest- Rate Swap Features: 1.No principal ever changes hands 2.Maturities: years possible years typical

Interest Rate Swaps 3.Two Types of Interest-Rate Swaps a.Coupon Swaps one counterparty pays a fixed rate one counterparty pays a fixed rate second counterparty pays a floating rate second counterparty pays a floating rate floating rate resets periodically based on a designated index floating rate resets periodically based on a designated index

Interest Rate Swaps 3.Two Types of Interest-Rate Swaps (continued) b.Basis swap two counterparties exchange floating interest payments based on the difference in reference rates

Interest Rate Swaps E.The Classic Swap Transaction - an example 1.Assumptions Counterparty A: BBB-rated credit Counterparty B: AAA-rated credit Fixed-Rates Available For A, 8.5% is best possible For B, 7.0% is best possible

Interest Rate Swaps 1. Assumptions (continued) Floating Rates Available For A 6-month LIBOR + 0.5% For B6-month LIBOR

Interest Rate Swaps E.The Classic Swap: Step-by-step Step 1: A receives a $100 million loan at LIBOR+50 points from a syndicate of floating- rate lenders (simultaneously) B issues a $100 million bond for 5 years fixed at 7%

THE CLASSIC SWAP (PART A) STEP ONE: Floating-rate Lenders COUNTERPARTY A Lend $100 million 5-year with resets BOND MARKET COUNTERPARTY B Issue $100 for 5 years

Interest Rate Swaps Step 2: The Swap Agreement (Part A) A borrows $100 million from BigBank and agrees to pay 7.35% for 5 years (.0735 x $100 million)

THE CLASSIC SWAP (PART A) STEP ONE: Floating-rate Lenders COUNTERPARTY A Lend $100 million 5-year with resets BIGBANK $100 M at 7.35%

Interest Rate Swaps In exchange for depositing its $100 million floating-rate loan proceeds with BigBank, the Bank agrees to pay Counterparty A at the 6-month LIBOR rate (resets to match the original loan resets)

THE CLASSIC SWAP (PART A) STEP ONE: Floating-rate Lenders COUNTERPARTY A Lend $100 million 5-year with resets BIGBANK $100 M at 7.35% Deposit earns 6-mo LIBOR

Interest Rate Swaps The results from Part A: Counterparty A has effectively borrowed at a fixed rate of 7.35% when otherwise the best the could have received in the fixed-rate market was 8.5%

Interest Rate Swaps Step 2: The Swap Agreement (Part B) B borrows from BigBank at the 6 month LIBOR floating rate for 5 years In exchange for the deposit of B’s bond proceeds of $100 million, BigBank agrees to pay B at 7.25%

THE CLASSIC SWAP (PART B) STEP TWO: Floating-rate Lenders COUNTERPARTY A BIGBANK BOND MARKET COUNTERPARTY B Borrow at LIBOR Deposit at 7.25%

Interest Rate Swaps The Result from Part B: Counterparty B has swapped a fixed- rate loan for a floating-rate loan with an effective cost of LIBOR -.25% when otherwise the best the could have obtained in the floating-rate market was a LIBOR-only loan.

Interest Rate Swaps Part C: The Gains to BigBank from the Swaps BigBank: Receives7.35% Pays (7.25%) ReceivesLIBOR Pays (LIBOR) Nets.01%

Interest Rate Swaps Part C: The Gains to BigBank from the Swap (continued) BigBank receives.001 x the notional principal ($100 million) = $100,000 annually for 5 years

Interest Rate Swaps F.Cost Savings CounterpartyNormalSwapNet A8.5% BLIBORL BigBank.10 Total 1.00

Currency Swaps G.Currency Swaps 1.Definition: an exchange of debt-service obligations an exchange of debt-service obligations denominated in one currency denominated in one currency purpose: purpose: 4for the service on an agreed upon principal amount of debt denominated in another

Currency Swaps 2.Motivation for Currency Swaps a.Replaces parallel loan b.Solve two potential problems: 1.) If no right of offset, default by one party does not release the other from making payments. Swaps have right of offset. Swaps have right of offset.

Currency Swaps 2).Parallel loans remain on the balance sheet whereas a currency swap does not

Currency Swaps 3.Difference between interest-rate and Currency swaps: a.Currency swaps have an exchange of principal at predetermined exchange rates

Interest-Rate and Currency Swaps H.Economic Advantages of Swaps 1.Overcome barriers when they exist to effective arbitrage such as legal restrictions on forwards legal restrictions on forwards different perceptions by investors of the creditworthiness of the two counterparties different perceptions by investors of the creditworthiness of the two counterparties tax differentials tax differentials

Interest-Rate and Currency Swaps H.Economic Advantages of Swaps (continued) 2.They provide long-term financing in foreign currencies

II.Structured Notes A.Definition: interest-bearing securities whose interest payments are by a formula set in advance B.Formula may be tied to a variety of different often complex factors

Structured Notes C.Purpose of Structured Notes 1.They allow firms to speculate on the direction, range, and volatility of interest rates 2.They also can be used for hedging purposes

Structured Notes D. Types of Structured Notes 1.Inverse floaters 2.Step-ups 3.Step-downs

III.Interest Rate Forwards and Futures A.Include: 1. Forward forwards 2.Forward rate agreements 3.Eurodollar futures

Interest Rate Forwards and Futures B.Forward Forwards 1.Definition: a contract that fixes an interest rate today on a future loan or deposit 2. Contract specifies –interest rate –principal amount –start and ending dates of future interest rate period

Interest Rate Forwards and Futures C.Forward Rate Agreements 1.Definition: a cash-settled, over-the-counter forward contract that allows –a fixed interest rate – the rate to be applied in the future on some notional principal amount – the parties to exchange interest payments

Interest Rate Forwards and Futures D.Eurodollar Futures 1.Definition: a cash-settled futures contract on a three-month, $1 million Eurodollar deposit that pays LIBOR 2.Features are similar to currency futures

IV.International Leasing A.Purposes 1.To defer and avoid taxes 2.To safeguard firm’s foreign subsidiary assets 3.To avoid currency controls

International Leasing B.Types of Leases 1. Operating Lease (true lease) ownership and the use of the asset are separatedownership and the use of the asset are separated agreement covers only part of the useful life of the assetagreement covers only part of the useful life of the asset

International Leasing B.Types of Leases 2.Financial lease extends over most of the economic life of the assetextends over most of the economic life of the asset noncancelablenoncancelable if cancelable, it requires substantial penalty to the lessorif cancelable, it requires substantial penalty to the lessor in effect, lessor borrows money and then purchases the assetin effect, lessor borrows money and then purchases the asset

if a financial lease, lessee allowed tax depreciation for the purchase price tax deduction for the interest factor lessor not entitled to tax benefits International Leasing 3.Tax Factors a lease that qualifies as a true lease for tax purposes is called a tax- oriented lease entitling lessee to 4deduct full value of lease payments

International Leasing 4if a financial lease, lessee allowed tax depreciation for the purchase pricetax depreciation for the purchase price tax deduction for the interest factortax deduction for the interest factor lessor not entitled to tax benefitslessor not entitled to tax benefits

V. LDC Debt-Equity Swaps A. The LDC Debt-Equity Market 1.enables investors to purchase the external debt of less- developed countries (LDC) to acquire equity or domestic currency in those same markets

LDC Debt-Equity Swaps B.Types of Debt Swaps and Rationale 1.LDC loans sell at deep discounts to their face value 2.Substantial variation can occur across countries

LDC Debt-Equity Swaps 3.Investors buy loans in expectation that credit ratings will increase 4.Arbitrage opportunities occur. The market offers a more favorable exchange rate that do official currency markets.

LDC Debt-Equity Swaps C.Costs and Benefits of Debt Swaps 1.Debt swaps and inflation 2.Impact on capital Formation 3.Effect on privatization