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7- Corporate Users of Financial Products

7- Corporate Users of Financial Products. Commercial Uses of Financial Products. Risk management/ hedging Companies enter into derivative arrangements to protect themselves from different risks Currency risk Market price risk (commodity such as oil) Interest rate risk Main products

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7- Corporate Users of Financial Products

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  1. 7- Corporate Users of Financial Products

  2. Commercial Uses of Financial Products • Risk management/ hedging • Companies enter into derivative arrangements to protect themselves from different risks • Currency risk • Market price risk (commodity such as oil) • Interest rate risk • Main products • Forwards and futures • Options and swaps

  3. COMMON DFIs - SWAPS • Swap Exchange of income streams, calculated with reference to changes in value of some underlying subject matter (interest rate, foreign currency, shares etc) • Largest markets are in: • interest rate swaps • currency swaps • commodity swaps (for agriculture and mining) • credit swaps • Idea is to shift / accept risk on one transaction for a similar transaction - alter risk profile

  4. Example 1 - interest rate swap £1 million Notional principal £1m LIBOR + 0.25% LIBOR + 0.25% 6.0%

  5. Interest rate swap • Periodic payments exchanged at agreed intervals, e.g. quarterly. Amounts normally netted off - if LIBOR is say 4.75%, bank pays £12,500, company pays £15,000; therefore company pays net £2,500. • Company may pay or receive lump sum if swap is terminated prematurely, or assigned • Company has fixed the cost of its borrowing - no longer exposed to interest rate risk • May be cheaper than issuing a fixed-rate bond

  6. Swaps - Example 1 Nov Notional Principal = $10m 10% + 0.25% Floating rate + 0.25% Borrower B Borrower A Bank 10% Floating rate 10% fixed rate Floating rate $14m loan $12m loan

  7. Swaps - Example 1 Feb floating rate = 9.6% Notional Principal = $10m 10% + 0.25% Fixed rate Floating rate + 0.25% 9.85% Borrower B Borrower A Bank Fixed rate10% Floating rate 9.6% 10% fixed rate Floating rate $14m loan $12m loan

  8. Swaps - Example 1 May floating rate = 10.2% Notional Principal = $10m 10% + 0.25% Floating rate + 0.25% 10.45% Borrower B Borrower A Bank 10% Floating rate 10.2% 10% fixed rate Floating rate $14m loan $12m loan

  9. Tax Issues • Does the character of swap payments depend on the underlying subject matter of the swap? • If the payments were made across border, how do you characterise them for treaty purposes? • Are gains and losses under interest rate swaps taxable or deductible for tax purposes? On every balance date? On realisation? • If taxable/deductible at every balance date (i.e. before the swap payments are made), what methods are used to calculate the amount that should be brought to tax?

  10. Tax Issue • Are payments made under the swap arrangements subject to withholding taxes?

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