Hedging Financial Market Exposure Interest Rate Swaps Cross Currency Interest Rate Swaps

1. Hedging Financial Market Exposure Interest Rate SwapsCross Currency Interest Rate Swaps

2. What is a Derivative?? “A contract or security, whose value is derived from the price or level changes in some other underlying security, index or other instrument.”- Wall Street Journal definition. A separate financial contract which alters one’s exposure to future changes in: interest rates, equity security prices, commodity prices or foreign exchange rates.

3. Interest Rate Swaps

4. Interest Rate Swaps Floating Rates of Interest: PRIME: “The base rate on corporate loans posted by at least 75% of the nations 30 largest banks.” The PRIME rate is subject to change on a daily basis.

5. Interest Rate Swaps Floating Rates of Interest: LIBOR: (London Interbank Offered Rate) “British Bankers Association average of interbank offered rates for dollar deposits in the London market based on quotations at 16 major banks.” The LIBOR rate is available for 1, 2, 3, 4, 5, 6 and 12 month maturity’s.

6. Interest Rate Swaps

7. Interest Rate Swaps

8. Interest Rate Swaps

9. ABC PNC Bank Interest Rate Swaps Libor + 2.00%

10. Swap Rate: 5.50% PNC Capital Markets ABC Libor Libor + 2.00% PNC Bank Interest Rate Swaps

11. Interest Rate Swaps Swap Details:Notional Amount: $1,000,000Start Date: August 7, 2001Maturity Date: August 7, 2006Amortization: $0 (bullet amortization)ABC Pays: 5.50% Swap Rate, Quarterly, Actual/360ABC Receives: Libor, Quarterly, Actual/360

12. Interest Rate Swaps

13. ABC Bondholder Interest Rate Swaps Fixed Coupon:7.25%

14. Libor + 1.75% PNC Capital Markets ABC Swap Rate: 7.25% Fixed Coupon:7.25% Bondholder Interest Rate Swaps

15. Interest Rate Swaps • Assess bank market versus corporate bond market/private placement market. • Issue debt in the market which has a “comparative advantage” in terms of spreads, covenants, etc. • Use Swaps and/or Reverse Swaps to implement the Fixed versus Floating strategy.

16. Cross Currency Interest Rate Swaps

17. Cross Currency Interest Rate Swaps • ABC has an opportunity to make a direct investment in Europe, utilizing EURO as the currency. • The “Investment” may consist of hard assets (real estate/equipment) or an operating company.

18. ABC Euro EURO Investment Bank of Euro Cross Currency Interest Rate Swaps Principal CashflowsInterest Cashflows

19. Cross Currency Interest Rate Swaps • Unfortunately for ABC, it is unable to raise EURO denominated financing from a European bank.

20. ABC Euro EURO Investment Bank of Euro Cross Currency Interest Rate Swaps Loan Request Principal CashflowsInterest Cashflows

21. Cross Currency Interest Rate Swaps • Fortunately for ABC, it does have a strong relationship with a domestic bank that is experienced in delivering international financing solutions. • ABC will raise USD financing. • ABC will then enter into a Cross Currency Interest Rate Swap.

22. Cross Currency Interest Rate Swaps • The Cross Currency Swap has these primary features: • Converts USD into EURO. Utilize EURO to make investment. • No foreign exchange risk, as EURO investment cash flows are converted to USD for debt service (P&I) based on a pre-determined, fixed exchange rate.

23. ABC Euro EURO Investment PNC Capital Markets ABC Cross Currency Interest Rate Swaps Principal CashflowsInterest Cashflows PNC Bank

24. ABC Euro EURO Investment PNC Capital Markets ABC Cross Currency Interest Rate Swaps USD Principal Principal CashflowsInterest Cashflows PNC Bank

25. ABC Euro EURO Investment PNC Capital Markets ABC Cross Currency Interest Rate Swaps EURO Principal Exchange USD Principal Exchange USD Principal Principal CashflowsInterest Cashflows PNC Bank

26. ABC Euro EURO Investment PNC Capital Markets ABC Cross Currency Interest Rate Swaps EURO Principal EURO Principal Exchange USD Principal Exchange USD Principal Principal CashflowsInterest Cashflows PNC Bank

27. ABC Euro EURO Investment PNC Capital Markets EURO Swap Rate ABC Libor PNC Bank Cross Currency Interest Rate Swaps EURO Fixed Rate EURO Principal EURO Principal Exchange USD Principal Libor Principal CashflowsInterest Cashflows

28. ABC Euro EURO Investment EURO Principal Exchange PNC Capital Markets EURO Swap Rate ABC USD Libor USD Principal Exchange PNC Bank Cross Currency Interest Rate Swaps EURO Fixed Rate EURO Principal USD Principal USD Libor Principal CashflowsInterest Cashflows

29. ABC Euro EURO Investment EURO Principal Exchange PNC Capital Markets EURO Swap Rate ABC USD Libor USD Principal Exchange PNC Bank Cross Currency Interest Rate Swaps 4 4 EURO Fixed Rate EURO Principal 9 5 3 10 6 7 11 2 1 USD Principal USD Libor 8 Principal CashflowsInterest Cashflows 12

30. Cross Currency Interest Rate Swaps Initial principal advances and use of proceeds:1) PNC Bank lends USD to ABC.2) ABC delivers USD to PNC Capital Markets.3) PNC Capital Markets delivers EURO to ABC.4) ABC lends EURO to ABC Euro.Debt Service Payments:5) ABC Euro pays EURO interest to ABC.6) ABC pays EURO Swap Rate to PNC Capital Markets.7) PNC Capital Markets pays USD Libor to ABC.8) ABC pays USD Libor to PNC Bank.Payoff Loan & Terminate Swap:9) ABC retires its EURO Loan from ABC.10) ABC delivers EURO to PNC Capital Markets.11) PNC delivers USD to ABC.12) ABC retires USD loan from PNC Bank.

31. Hedging Financial Market Exposure