1. C H A P T E R 18
Long-Term Financing

2. D. Reducing Exchange Rate Risk
3. Currency Swaps a. A currency swap enables firms to exchange currencies at periodic intervals b. Many MNCs simultaneously swap interest payments and currencies

3. Illustration of a Currency Swap
18.7

4. E. Interest Rate Risk from Debt Financing
3. Plain Vanilla Swap - Interest Rate Swaps
Party A prefers issuing fixed rate bond but it can get lower floating rate than Party B;
Party B prefers issuing floating rate bond but it can get lower fixed rate than Party A;
Party A issue floating rate bond and Party B issue fixed rate bond and then two parties swap the payment.
So both parties benefit and can get what they want at the best rate which is impossible without the counter party.

5. E. Interest Rate Risk from Debt Financing
3. Plain Vanilla Swap - Interest Rate Swaps
Example:
Fixed rate Floating Rate
Quality Co. 9% LIBOR+ 0.5%
Risky Co % LIBOR + 1%
Answer:
Quality borrow at fixed 9% from market and pays LIBOR + 0.5% to Risky as part of the swap  Risky borrow at LIBOR+1% from market and pays 9.5% fixed to Quality as part of the swap Quality’s net is 0.5% and Risky’s nest is also 0.5% (it pays back 9.5% in place of 10.5%, so net 1%; but it receives LIBOR+0.5% but pays LIBOR+1%, so net -0.5%; Overall, net of 0.5%)  This plain vanilla swap benefits both parties  Depending on the LIBOR rate, both parties settle the net transactions of the swap, which is: Risky pays Quality fixed 9.5% and Quality pays Risky floating LIBOR+0.5%.

6. Illustration of an Interest Rate Swap
18.10

7. E. Interest Rate Risk from Debt Financing
3. Plain Vanilla Swap - Interest Rate Swaps
Example:
Fixed rate Floating Rate
Quality Co. 9% LIBOR+ 0.5%
Risky Co % LIBOR + 1%
LIBOR Quality Payment Risky Payment Net
8% 8%+0.5% 9.5% Risky pays Quality 1%
7% 7%+0.5% 9.5% Risky pays Quality 2%
5.5% 5.5%+0.5% 9.5% Risky pays Quality 3.5%
9% 9%+0.5% 9.5% No payment
10% 10%+0.5% 9.5% Quality pays Risky 1%