1. Lecture 13

2. Birth 1981 Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principal Key points Spread inefficiencies Same notation principal Only interest exchanged

3.  “Plain Vanilla Swap” - (generic swap)  fixed rate payer  floating rate payer  counterparties  settlement date  trade date  effective date  terms  Swap Gain = fixed spread - floating spread

4. Example (vanilla/annually settled) XYZABC fixed rate10%11.5% floating ratelibor +.25libor +.50 Q: if libor = 7%, what swap can be made 7 what is the profit (assume $1mil face value loans) A: XYZ borrows $1mil @ 10% fixed ABC borrows $1mil @ 7.5% floating XYZ pays floating @ 7.25% ABC pays fixed @ 10.50%

5. Example - cont Benefit to XYZNet position floating +7.25 -7.250 fixed +10.50 -10.00+.50 Net gain+.50% Benefit ABCNet Position floating +7.25 - 7.50-.25 fixed -10.50 + 11.50+1.00 net gain+.75%

6. Example - cont Settlement date ABC pmt 10.50 x 1mil = 105,000 XYZ pmt 7.25 x 1mil = 72,500 net cash pmt by ABC = 32,500 if libor rises to 9% settlement date ABC pmt 10.50 x 1mil = 105,000 XYZ pmt 9.25 x 1mil= 92,500 net cash pmt by ABC = 12,500

7.  transactions  rarely done direct  banks = middleman  bank profit = part of “swap gain” example - same continued XYZ & ABC go to bank separately XYZ term = SWAP floating @ libor +.25 for fixed @ 10.50 ABC terms = swap floating libor +.25 for fixed 10.75

8. Example - cont settlement date - XYZ Bank pmt 10.50 x 1mil = 105,000 XYZ pmt 7.25 x 1mil = 72,500 net Bank pmt to XYZ = 32,500 settlement date - ABC Bank pmt 7.25 x 1mil = 72,500 ABC pmt 10.75 x 1mil = 107,500 net ABC pmt to bank = 35,000 bank “swap gain” = +35,000 - 32,500 = +2,500

9. Example - cont benefit to XYZ floating 7.25 - 7.25 = 0 fixed 10.50 - 10.00 = +.50 net gain.50 benefit to ABC floating 7.25 - 7.50 = -.25 fixed -10.75 + 11.50 = +.75net gain.50 benefit to bank floating +7.25 - 7.25 = 0 fixed 10.75 - 10.50 = +.25net gain +.25 total benefit = 12,500 (same as w/o bank)

10. Similar to interest rate swaps Same type loan, just diff currency WHY? example: you have an investment in Japan Project is financed with US bonds You look for SWAP partner so you can emulate holding Japanese bonds JavaYahooprincipal Yen loan11%12%$ 1 mil $ loan8%11.1%or Y120

11. example - continued  Java borrows $1mil @ 8%  Yahoo borrows Y120mil @ 12%  Intl. Bank arranges swap  Java swaps 8% $ loan for 10.3% yen loan w/bank  Yahoo swaps 12% yen loan for 10.4% $ loan w/bank total available benefit = (11.1-8) - (12-11) = 2.1%

12. example - continued benefit to Java $ loan +8 - 8 = 0 Yen loan +11 - 10.3 =.7net gain +.7% benefit to Yahoo $ loan 11.1 - 10.4 = +.7 yen loan -12 + 12 = 0net gain =.7% benefit to bank $ loan +10.4 - 8 = +2.4 yen loan - 12 + 10.3 = -1.7net gain +.7%