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Swaps

Swaps. Transform assets or liabilities by “swapping” cash flows with another party Allows a party with a comparative advantage in a certain money market segment to exploit that advantage while operating in other segments. Can mitigate risks to cash flow

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Swaps

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  1. Swaps Transform assets or liabilities by “swapping” cash flows with another party Allows a party with a comparative advantage in a certain money market segment to exploit that advantage while operating in other segments. Can mitigate risks to cash flow Serve the same purpose as forward or futures contract for longer period at less cost

  2. Objectives • Identify the elements of interest rate swaps and foreign currency swaps • Identify situations where entering into a swap reduces risk • Structure a swap • Calculate the rate where entering into a swap becomes advantageous

  3. How swaps work • Transform a liability • Transform an asset • Reduce costs associated with inconsistent pricing across different international credit market segments • Serve the same purpose as long-dated forward contracts for less cost • Do not require participating parties to have similar credit quality • Intermediary facilitates swap between parties for a fee

  4. Structure Shell and Microsoft each make yearly payments on 5-year notes valued at $100 million Rates • Shell - 1-Year LIBOR minus one year (5.17% floating) • Microsoft pays 5% fixed Yearly payments on notes: • Microsoft - $5 million • Shell - $5.17 million Shell Microsoft 5% LIBOR

  5. Structure Each party agrees to make the other’s yearly payments Yearly payments on notes: • Shell pays Microsoft $5 million • Microsoft pays Shell $5.17 million • General structure - Microsoft pays Shell $170,000 Libor decreases to 4.9%: • Shell pays Microsoft $5 million • Microsoft pays Shell $4.9 million • General structure - Shell pays Microsoft $100,000 LIBOR Shell Microsoft 5% LIBOR 5%

  6. Outcome Transformation of respective liabilities: • Shell now pays 5% fixed • Microsoft now pays 1-Year LIBOR minus one year

  7. Identify situations where entering into a swap reduces risk • Fixed loan when interest rates are falling • Floating interest when rates are increasing • Inflows of foreign currency when home currency is appreciating • Outflows of foreign currency when home currency is depreciating

  8. Example • Click and Coval, “International Financial Management,” P 288

  9. Calculate the break-even rate where entering into a swap becomes advantageous Principal and present value of payments: (Swap Principal – Swap Fees)/So = P1/(1 +i) + P2/(1 + i)^2 + P3/(1 + i)^3 + Pn /(1+i)^n where Sº is the current rate of exchange and P is the loan payment

  10. Exercise • Shell plans to build a refinery in Saudi Arabia and Al Rajhi Bank plans to build a bank in the Netherlands. • Al Rajhi Bank borrows 600 million Saudi Riyals for ten years at 9.6 percent interest on the black market and agrees to swap payments with Shell, which has borrowed 100 million Euros for ten years at 9.8 percent interest.

  11. Objectives • Identify the elements of interest rate swaps and foreign currency swaps • Identify situations where entering into a swap reduces risk • Structure a swap • Calculate the rate where entering into a swap becomes advantageous

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