1. Chapter 8 Interest Rate Derivatives (Textbook Chapter 9)

2. INTEREST RATE AND CURRENCY SWAPS A. INTEREST RATE SWAPS 1. Definition an agreement between 2 parties to exchange interest payments for a specific maturity on an agreed notional amount. 2

3. HOW THE CLASSIC SWAP WORKS A. INTEREST RATE SWAPS (con’t) 2. Notional principal: a reference amount used only to calculate interest expense but never repaid. 3. Maturities: less than 1 to over 15 years 3

4. THE CLASSIC SWAP 4. Types a. Coupon swap: one party pays a fixed rate calculated at the time of trade as a spread to a particular government bond, and the other side pays a floating rate that resets periodically throughout the life of the deal against a designated index. b. Basis swap: two parties exchange floating interest payments based on different reference rates. 4

5. THE CLASSIC SWAP 5.LIBOR (London Interbank Offered Rate): the most important reference rate in a swap 6. Eurocurrency: Freely convertible currency deposited in a bank outside its country of origin, such as Eurodollar Eurobond: Bond outside the country in whose currency it is denominated. 7. Swap Usage: To reduce potential risk and costs. 5

6. THE CLASSIC SWAP 8. Classic Swap Transaction: Counterparties A and B both require US$100 million for a five- year period. To reduce their financing risks, A would like to borrow at a fixed rate, whereas B would prefer to borrow at a floating rate. Suppose that A is a company with a BBB rating and B is an AAA-rated bank. The cost to each party of accessing either the fixed-rate or the floating-rate market for a new five-year debt issue is as follows: 6

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8. THE CLASSIC SWAP 8

9. THE CLASSIC SWAP – Example Suppose that on December 31, 2008, IBM issued a two-year, floating-rate bond in the amount of $100 million on which it pays LIBOR6 – 0.5% semiannually, with the first payment due on June 30, 2009. Because IBM would prefer fixed-rate payments, it entered into a swap with Citibank as the intermediary on December 31, 2008. Under the swap contract, IBM agreed to pay Citibank an annual rate of 8% and to receive LIBOR6. All payments are to be made on a semiannual basis. In effect, IBM used a swap to convert its floating-rate debt into a fixed-rate bond yielding 7.5%. 9

10. THE CLASSIC SWAP – Example 10

11. THE CURRENCY SWAP B.Currency Swaps 1. Definition two parties exchange foreign currency- denominated debt at periodic intervals. 2. Purpose: similar to parallel loan 11

12. THE CURRENCY SWAP 12

13. THE CURRENCY SWAP 3.Differences of a Currency Swap: a. Currency swap is not a loan b. No interest expense; no balance sheet entry c. The right to offset any non-payment is more firmly established 13

14. THE CURRENCY SWAP – Example Suppose that Dow Chemical is looking to hedge some of its euro exposure by borrowing in euros. At the same time, French tire manufacturer Michelin is seeking dollars to finance additional investment in the U.S. market. Both want the equivalent of $200 million in fixed-rate financing for 10 years. Dow can issue dollar-denominated debt at a coupon rate of 7.5% or euro-denominated debt at a coupon rate of 8.25%. Equivalent rates for Michelin are 7.7% in dollars and 8.1% in euros. Both companies have similar credit ratings. 14

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16. INTEREST RATE/CURRENCY SWAPS C. Interest Rate/Currency Swaps 1. Similarities between Interest Rate and Currency Swaps a. Avoid exchange rate risk b. Exchange rate is only a reference to determine amounts exchanged 2. The most common form: converts a fixed-rate liability in one currency into a floating-rate liability in second currency 16

17. INTEREST RATE/CURRENCY SWAPS – Example Suppose that Dow Chemical decides it prefers to borrow floating-rate euros instead of fixed-rate euros, whereas Michelin maintains its preference for fixed-rate dollars. Assume that Dow Chemical can borrow floating-rate euros directly at LIBOR + 0.35%, versus a cost to Michelin of borrowing floating-rate euros of LIBOR + 0.125%. As before, given Dow’s cost of borrowing dollars of 7.5% versus Michelin’s cost of 7.7%, the best way for them to achieve their currency and interest rate objective is to issue debt in their own currencies and then swap the proceeds and future debt-service payments. 17

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19. THE CURRENCY SWAP D. Economic Benefits of Swaps: 1. Provides a real economic benefit to both parties if a barrier exists to prevent arbitrage from functioning fully. 2. Allows firms to lower their cost of foreign exchange risk management by arbitraging their relative access to different currency markets. 3. Currency swaps are often used to provide long- term financing in foreign currencies. 19

20. INTEREST RATE FORWARDS AND FUTURES Forward and futures contracts: - three types used to manage interest rate risk A.Forward forwards B.Forward rate agreements C.Eurodollar futures 20

21. INTEREST RATE FORWARDS AND FUTURES A. Forward forwards 1.a contract that fixes an interest rate today on a future loan or deposit. 2.Contract conditions: - specific interest rate - principal amount of future loan - start and ending dates of future interest rate period 21

22. FORWARD FORWARDS – Example Suppose that Telecom Argentina needs to borrow $10 million in six months for a three-month period. It could wait six months and borrow the money at the then- current interest rate. Rather than risk a significant rise in interest rates over the next six months, however, Telecom Argentina decides to enter into a forward forward with Daiwa Bank that fixes this rate at 8.4% per annum. 22

23. FORWARD FORWARDS 3. Forward forward rate can be found through arbitrage Suppose a company wishes to lock in a six-month rate on a $1 million Eurodollar deposit to be placed in three months. It can buy a forward-forward or it can create its own. Suppose it can borrow or lend at LIBOR. It can derive a three-month forward rate on LIBOR6 by simultaneously borrowing the present value of $1 million for three months and lending that same amount of money for nine months. 23

24. FORWARD FORWARDS 24

25. INTEREST RATE FORWARDS AND FUTURES B. Forward rate agreement (FRA) 1. cash-settled 2. over-the-counter forward contract company fixes an interest rate applied to a specified future interest period on a notional amount. 25

26. FORWARD RATE AGREEMENT – Example Suppose that Unilever needs to borrow $50 million in two months for a six-month period. To lock in the rate on this loan, Unilever buys a “2 × 6” FRA on LIBOR at 6.5% from Bankers Trust for a notional principal of $50 million. This means that Bankers Trust has entered into a two-month forward contract on six-month LIBOR. Two months from now, if LIBOR6 exceeds 6.5%, Bankers Trust will pay Unilever the difference in interest expense. If LIBOR6 is less than 6.5%, Unilever will pay Bankers Trust the difference. 26

27. INTEREST RATE FORWARDS AND FUTURES C. Eurodollar Futures 1.A cash-settled futures contract for a 3-month, $1 million Eurodollar deposit paying LIBOR 2.Contracts traded on: a.Chicago Mercantile Exchange b.London International Financial Futures Exchange c.Singapore International Monetary Exchange 27

28. INTEREST RATE FORWARDS AND FUTURES 3. Quote = 100 – (annualized forward interest rate) 28

29. EURODOLLAR FUTURES - Example In late June, a corporate treasurer projects that a shortfall in cash flow will require a $10 million bank loan on September 16. The contractual loan rate will be LIBOR3 + 1%. LIBOR3 is currently at 5.63%. The treasurer can use the September Eurodollar futures, which are currently trading at 94.18, to lock in the forward borrowing rate. This price implies a forward Eurodollar rate of 5.82%. By selling 10 September Eurodollar futures contract, the corporate treasurer ensures a borrowing rate of 6.82% for the three-month period beginning September 16. This rate reflects the bank’s 1% spread above the rate locked in through the futures contract. 29