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

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

3. 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 + 0.30% Hypothetical ResourcesBBB11.90%T-Bill + 0.80%

4. 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 + 0.30% Hypothetical ResourcesBBB11.90%T-Bill + 0.80% 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

5. 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 + 0.30% Hypothetical ResourcesBBB11.90%T-Bill + 0.80% 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 …

6. 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 -10.00%Borrow $10 million in Commercial Paper - (TB + 0.80)%

7. Chapter 27: Swap Agreements Swap a fixed payment © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds -10.00 %Borrow $10 million in Commercial Paper - (TB + 0.80)% Swap: fixed payment+11.00 %Swap: fixed payment-11.00 %

8. Chapter 27: Swap Agreements Swap a variable payment © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds -10.00 %Borrow $10 million in Commercial Paper - (TB + 0.80)% Swap: fixed payment +11.00 % Swap: fixed payment -11.00 % Swap: variable payment - (TB +0.70)% Swap: variable payment +(TB + 0.50)% 0.20% to intermediary

9. Chapter 27: Swap Agreements Net debt payment © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds - 10.00 %Borrow $10 million in Commercial Paper - (TB + 0.80)% Swap: fixed payment + 11.00 % Swap: fixed payment - 11.00 % Swap: variable payment - (TB + 0.70)% Swap: variable payment +(TB + 0.50)% NET:- (TB - 0.30)%NET:- 11.30 % -10.00 + 11.00 – TB - 0.70 =- TB + 0.30 = - (TB - 0.30) - TB - 0.80 - 11.00 + TB + 0.50 =- 11.30

10. 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 + 0.30% Hypothetical ResourcesBBB11.90%T-Bill + 0.80% 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

11. 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 + 0.30% Hypothetical ResourcesBBB11.90%T-Bill + 0.80% Difference:190 50 Total Gain = 1.40% = 140 basis points

12. 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

13. Chapter 27: Swap Agreements Engineering the Swap © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds - 10.00 %Borrow $10 million in Commercial Paper - (TB + 0.80)% NET:- (TB - 0.30)%NET:- 11.30 % -(TB + 0.30) + 0.60 = - (TB - 0.30)-11.90 + 0.60 = - 11.30

14. Chapter 27: Swap Agreements Engineering the Swap © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds - 10.00 %Borrow $10 million in Commercial Paper - (TB + 0.80)% Swap: fixed payment + 11.00 % Swap: fixed payment - 11.00 % NET:- (TB - 0.30)%NET:- 11.30 % Set the fixed payment

15. Chapter 27: Swap Agreements Engineering the Swap © Oltheten & Waspi 2012 Bank of AmericaHypothetical Resources Borrow $10m in 10 year bonds - 10.00 %Borrow $10 million in Commercial Paper - (TB + 0.80)% Swap: fixed payment + 11.00 % Swap: fixed payment - 11.00 % Swap: variable payment - (TB + 0.70)% Swap: variable payment +(TB + 0.50)% NET:- (TB - 0.30)%NET:- 11.30 % Calculate the variable payment

16. 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 + 0.80 %.20% T-Bill + 0.50 % 11.00% $10,000,000 Notional Principal Amount

17. 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

18. Chapter 27: Swap Agreements T-Bill Rate: 9.0% © Oltheten & Waspi 2012 $75,000 Bank of America T-Bill – 0.30 8.7% Long Term Debt Market Commercial Paper Market Hypothetical Resources 11.30% Intermediary 10.00% T-Bill +0.80 9.80%.20% 11.00% $10,000,000 Notional Principal Amount T-Bill +0.50 9.50 % 1.50%

19. Chapter 27: Swap Agreements T-Bill Rate: 10.5% © Oltheten & Waspi 2012 $0 Bank of America T-Bill – 0.30 10.2% Long Term Debt Market Commercial Paper Market Hypothetical Resources 11.30% Intermediary 10.00% T-Bill +0.80 11.30%.20% 11.00% $10,000,000 Notional Principal Amount T-Bill +0.50 11.00 %

20. Chapter 27: Swap Agreements T-Bill Rate: 12.0% © Oltheten & Waspi 2012 $75,000 Bank of America T-Bill – 0.30 11.7% Long Term Debt Market Commercial Paper Market Hypothetical Resources 11.30% Intermediary 10.00% T-Bill +0.80 12.80%.20% 11.00% $10,000,000 Notional Principal Amount T-Bill +0.50 12.50 % 1.50%

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

22. 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.

23. 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%

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

25. 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%

26. 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- 12.60%Original Dollar Rate- 7.00% Swap advantage+.70%Swap advantage+.70% Net:- 11.90%Net:- 6.30%

27. 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%

28. 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%

29. 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

30. Chapter 27: Swap Agreements Payment Flow © Oltheten & Waspi 2012 With no swap Airlease Euro Debt Market US Dollar Debt Market Boeing Intermediary €10m @13.00% $9m * 5.00 % $9m * 6.30 % €10m * 13.00% €10m * 11.90% $9m * 5.00 % $9m * 7.00 % €10m @12.60%

31. 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 %

32. 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 €.

33. Chapter 27: Swap Agreements Intermediary’s ForEx Risk © Oltheten & Waspi 2012 $1.0636 $1.40 -$24,000

34. Swap Agreements