IX: Market Innovations 27: Swap Agreements Credit Arbitrage Swap Currency Swap

Chapter 27: Swap Agreements Credit Arbitrage Swap © Oltheten & Waspi 2012

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Credit Arbitrage Swap  SWAP debt payments to get from the market in which you can borrow at the lowest rate to the market in which you want to pay interest. Need to borrow $10m Rating 10 Year Bond Rate 6 month Commercial Paper Rate Bank of AmericaAAA10.00%T-Bill % Hypothetical ResourcesBBB11.90%T-Bill %

Chapter 27: Swap Agreements Credit Arbitrage Swap Need to borrow $10m Rating 10 Year Bond Rate 6 month Commercial Paper Rate Bank of AmericaAAA10.00%T-Bill % Hypothetical ResourcesBBB11.90%T-Bill % 190 bp 50 bp Market in which we would rather pay interest Market in which BofA has an absolute advantage Market in which we have a comparative advantage © Oltheten & Waspi 2012

Chapter 27: Swap Agreements Credit Arbitrage Swap © Oltheten & Waspi 2012 Need to borrow $10m Rating 10 Year Bond Rate 6 month Commercial Paper Rate Bank of AmericaAAA10.00%T-Bill % Hypothetical ResourcesBBB11.90%T-Bill % 190 bp 50 bp … and swap into a fixed interest payment … and swap into a variable interest payment BofA will borrow in the 10yr fixed market … HR will borrow in the 6 month fixed market …

Chapter 27: Swap Agreements Borrow © Oltheten & Waspi 2012  Each company borrows in the market in which it has a comparative advantage. Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds %Borrow $10 million in Commercial Paper - (TB )%

Chapter 27: Swap Agreements Swap a fixed payment © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds %Borrow $10 million in Commercial Paper - (TB )% Swap: fixed payment %Swap: fixed payment %

Chapter 27: Swap Agreements Swap a variable payment © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds %Borrow $10 million in Commercial Paper - (TB )% Swap: fixed payment % Swap: fixed payment % Swap: variable payment - (TB +0.70)% Swap: variable payment +(TB )% 0.20% to intermediary

Chapter 27: Swap Agreements Net debt payment © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds %Borrow $10 million in Commercial Paper - (TB )% Swap: fixed payment % Swap: fixed payment % Swap: variable payment - (TB )% Swap: variable payment +(TB )% NET:- (TB )%NET: % – TB =- TB = - (TB ) - TB TB =

Chapter 27: Swap Agreements Credit Arbitrage Swap © Oltheten & Waspi 2012 Need to borrow $10m Rating 10 Year Bond Rate 6 month Commercial Paper Rate Bank of AmericaAAA10.00%T-Bill % Hypothetical ResourcesBBB11.90%T-Bill % 190 bp 50 bp Net Payment is 11.30% Net payment is T-Bill – 0.30% Gain of 0.60% Intermediary gets 0.20% Total Gains from Swap: 140 basis points

Chapter 27: Swap Agreements Credit Arbitrage Swap © Oltheten & Waspi 2012 Need to borrow $10m Rating 10 Year Bond Rate 6 month Commercial Paper Rate Bank of AmericaAAA10.00%T-Bill % Hypothetical ResourcesBBB11.90%T-Bill % Difference: Total Gain = 1.40% = 140 basis points

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Engineering the Swap  Calculate the advantage  140 basis points  Distribute the advantage  60 basis points to Bank of America  60 basis points to Hypothetical Resources  20 basis points to the Intermediary  Calculate the swap backwards from the bottom line

Chapter 27: Swap Agreements Engineering the Swap © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds %Borrow $10 million in Commercial Paper - (TB )% NET:- (TB )%NET: % -(TB ) = - (TB ) =

Chapter 27: Swap Agreements Engineering the Swap © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds %Borrow $10 million in Commercial Paper - (TB )% Swap: fixed payment % Swap: fixed payment % NET:- (TB )%NET: % Set the fixed payment

Chapter 27: Swap Agreements Engineering the Swap © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds %Borrow $10 million in Commercial Paper - (TB )% Swap: fixed payment % Swap: fixed payment % Swap: variable payment - (TB )% Swap: variable payment +(TB )% NET:- (TB )%NET: % Calculate the variable payment

Chapter 27: Swap Agreements Swap: Payment Flow © Oltheten & Waspi 2012 Bank of America T-Bill – 0.30 Long Term Debt Market Commercial Paper Market Hypothetical Resources 11.30% Intermediary 10.00% T-Bill %.20% T-Bill % 11.00% $10,000,000 Notional Principal Amount

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Swap Payments  Suppose the T-Bill rate is  9.0% at the end of 12 months  10.5% at the end of 6 months  12.0% at the end of 18 months

Chapter 27: Swap Agreements T-Bill Rate: 9.0% © Oltheten & Waspi 2012 $75,000 Bank of America T-Bill – % Long Term Debt Market Commercial Paper Market Hypothetical Resources 11.30% Intermediary 10.00% T-Bill %.20% 11.00% $10,000,000 Notional Principal Amount T-Bill % 1.50%

Chapter 27: Swap Agreements T-Bill Rate: 10.5% © Oltheten & Waspi 2012 $0 Bank of America T-Bill – % Long Term Debt Market Commercial Paper Market Hypothetical Resources 11.30% Intermediary 10.00% T-Bill %.20% 11.00% $10,000,000 Notional Principal Amount T-Bill %

Chapter 27: Swap Agreements T-Bill Rate: 12.0% © Oltheten & Waspi 2012 $75,000 Bank of America T-Bill – % Long Term Debt Market Commercial Paper Market Hypothetical Resources 11.30% Intermediary 10.00% T-Bill %.20% 11.00% $10,000,000 Notional Principal Amount T-Bill % 1.50%

Chapter 27: Swap Agreements Currency Swap © Oltheten & Waspi 2012

Chapter 27: Swap Agreements Currency Swap © Oltheten & Waspi 2012 Rating Rate in the USA Euro Rate Boeing Needs to borrow €10m AAA5.00%12.60% Airlease Needs to borrow $9m BBB7.00%13.00% Difference200 bp40 bp Each company has a comparative advantage in the “wrong” currency so we use a swap to put each company in the target currency at a lower rate.

Chapter 27: Swap Agreements Borrow © Oltheten & Waspi 2012  Each company borrows in the market in which it has a comparative advantage. BoeingAirlease Borrow $9m-5.00%Borrow €10m-13.00%

Chapter 27: Swap Agreements Swap Principal © Oltheten & Waspi 2012 Boeing(€10m)Airlease($9m) Borrow $9m-5.00%Borrow €10m-13.00%

Chapter 27: Swap Agreements Neutralize Currency Risk © Oltheten & Waspi 2012 Boeing(€10m)Airlease($9m) Borrow $9m-5.00%Borrow €10m-13.00% Swap: Dollars+ $9m * 5.00%Swap: Euros+ €10m * 13.00%

Chapter 27: Swap Agreements Calculate the advantage © Oltheten & Waspi 2012 Total Advantage: 160 basis points Boeing(€10m)Airlease($9m) Borrow $9m-5.00%Borrow €10m-13.00% Take 20 basis points for the Intermediary and distribute the remaining 140 basis points equally Original Euro Rate %Original Dollar Rate- 7.00% Swap advantage+.70%Swap advantage+.70% Net: %Net:- 6.30%

Chapter 27: Swap Agreements Distribute the advantage © Oltheten & Waspi 2012 Boeing(€10m)Airlease($9m) Borrow $9m-5.00%Borrow €10m-13.00% Swap: Dollars+ $9m * 5.00%Swap: Euros+ €10m * 13.00% Net:- €10m * 11.90%Net:- $9m * 6.30%

Chapter 27: Swap Agreements Calculate the Swap © Oltheten & Waspi 2012 Boeing(€10m)Airlease($9m) Borrow $9m-5.00%Borrow €10m-13.00% Swap: Dollars+ $9m * 5.00%Swap: Euros+ €10m * 13.00% Swap: Euros- €10m * 11.90%Swap: Dollars- $9m * 6.30% Net:- €10m * 11.90%Net:- $9m * 6.30%

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Currency Swap  We have completely eliminated the foreign exchange risk for both counterparties by transferring exchange risk completely to the Intermediary

Chapter 27: Swap Agreements Payment Flow © Oltheten & Waspi 2012 With no swap Airlease Euro Debt Market US Dollar Debt Market Boeing Intermediary $9m * 5.00 % $9m * 6.30 % €10m * 13.00% €10m * 11.90% $9m * 5.00 % $9m * 7.00 %

Chapter 27: Swap Agreements Payment Flow © Oltheten & Waspi 2012 Airlease Boeing Intermediary + 1.3% of $9m - 1.1% of €10m Net: 0.20% + All the exchange risk $9m * 6.30 % €10m * 13.00% €10m * 11.90% $9m * 5.00 %

Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Intermediary’s Foreign Exchange Risk  Every six months the Intermediary  Takes in ½(1.3% of $9m) = $58,500.  Pays out ½(1.1% of €10m) = €55,000.  Profit:  Π = $58,500 - €55,000 * $ exchange €.

Chapter 27: Swap Agreements Intermediary’s ForEx Risk © Oltheten & Waspi 2012 $ $1.40 -$24,000

Swap Agreements