1. Swaps: Introduction

2. Swaps Interest Rate Swaps Plain Vanilla Cash Flows Structure Revaluation

3. Plain Vanilla Swaps Fixed Interest Payments for Floating Interest Payments Swap Buyer is Fixed Rate Payor Assume 4 year swap of 10% fixed rate payments vs. unknown LIBOR on $100,000,000 notional principal (NP). Note, no payments up front or terminally. Only NET interest payments between parties.

4. Plain Vanilla Swap Payments are: LIBOR rates: 9.5, 10.5, 9 and 10.5 TimeLIBOR Pymt$ PymtDiff. 1$9.5 million$10Mill-500K 2$10.5 million$10Mill+500K 3$9.0 million$10Mill-1Mill 4$ 10.5 million$10Mill+500K

5. Point of Plain Vanilla Swap Without adjustment to existing securities, Floating became Fixed, and Fixed became Floating. Floating ID’d at start of each period! Lower Transaction Costs. Ability to Activate Perceptions: Fixed wants to be Floating if rates are falling. Floating wants to be Fixed if rates are rising.

6. Structuring a Swap Observe interest rates on yield curve: Interest Rate 6 month 1 year 8% 10%

7. Forward Rates Rate of 6-month loan in 6 months (6-month FRA, termed a 6x12). A 1-year rate must be equivalent to 6-month rate combined with 6x12 rate. (1 + 0 R 12 ) = (1+ ½ 0 R 6 )(1+ ½ 6 R 12 ) Thus, price 6x12 off of known 6 & 12 month rates.

8. (1 + 0 R 12 ) = (1+ ½ 0 R 6 )(1+ ½ 6 R 12 ) (1+.10) = (1 + ½ (.08)) * (1 + ½ ( 6 R 12 )) 6 R 12 = [(1.10/1.04) – 1] * 2 = 11.54% Floating CFs as a % of any face amount will be: 6-month:.08 * ½ =.04 1-year:.1154 * ½ =.0577 Structuring a Swap

9. Fixed Payments are where: (.04 – Fixed) (.0577 – Fixed) 0 = -------------------- + ----------------------- (1 + ½ (.08)) (1.10) Fixed =.0486  9.72% Fixed (annual)

10. Swap Structure (on $100M in Notional Prin.) Now6mo1yr $4M$5.77M $4.86M $0.86M Pymt From Fltg to Fixed $0.91M Pymt From Fixed to Fltg -$0.85M / (1.04) + $0.91M / (1.10) = 0

11. Swap Revaluation (Marking-to-Market) What if rates jumped 1% next day? (6-month=9%, 1-year=11%) (1 + 0 R 12 ) = (1+ ½ 0 R 6 )(1+ ½ 6 R 12 ) (1+.11) = (1 + ½ (.09)) * (1 + ½ ( 6 R 12 )) 6 R 12 = [(1.11/1.045) – 1] * 2 = 12.44% 1-yr CF now.1244*½ =.0622

12. Swap Revaluation 6-month CF does not change as determined at swap origination Now6mo1yr $4M$6.22M $4.86M $0.86M Pymt From Fltg to Fixed $1.36M Pymt From Fixed to Fltg -$0.85M / (1.045) + $1.36M / (1.11) = $0.40M Gain to Fixed Rate Payor (on $100M NP)