Description
This is a presentation describes Swaps and discusses topics like cash flows, interest rate swaps, comparative advantage, currency swaps with the examples of Microsoft, IBM, BP, GM , Qantas
SWAPS
NATURE OF SWAPS
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules
2
AN EXAMPLE OF A “PLAIN VANILLA” INTEREST RATE SWAP
? An
agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million ? Next slide illustrates cash flows that could occur
CASH FLOWS TO MICROSOFT
---------Millions of Dollars--------LIBOR FLOATING Date Rate FIXED Net Cash Flow Cash Flow Cash Flow +2.10 –2.50 –0.40
Mar.5, 2004
Sept. 5, 2004
4.2%
4.8%
Mar.5, 2005
Sept. 5, 2005 Mar.5, 2006
5.3%
5.5% 5.6%
+2.40
+2.65 +2.75
–2.50
–2.50 –2.50
–0.10
+0.15 +0.25
Sept. 5, 2006
Mar.5, 2007
5.9%
6.4%
+2.80
+2.95
–2.50
–2.50
+0.30
+0.45
TYPICAL USES OF AN INTEREST RATE SWAP
?
Converting a liability from
? ?
fixed rate to floating rate floating rate to fixed rate
fixed rate to floating rate floating rate to fixed rate
?
Converting an investment from
? ?
INTEL AND MICROSOFT (MS) TRANSFORM A LIABILITY
5% 5.2%
Intel
LIBOR
MS
LIBOR+0.1%
FINANCIAL INSTITUTION IS INVOLVED
4.985% 5.2%
5.015%
Intel
LIBOR
F.I.
LIBOR
MS
LIBOR+0.1 %
Financial Institution has two offsetting swaps
INTEL AND MICROSOFT (MS) TRANSFORM AN ASSET
5%
4.7%
Intel
LIBOR-0.2% LIBOR
MS
FINANCIAL INSTITUTION IS INVOLVED
4.985%
5.015% 4.7%
Intel
LIBOR-0.2% LIBOR
F.I.
LIBOR
MS
QUOTES BY A SWAP MARKET MAKER
Maturity
2 years 3 years 4 years
Bid (%)
6.03 6.21 6.35
Offer (%)
6.06 6.24 6.39
Swap Rate (%)
6.045 6.225 6.370
5 years
7 years 10 years
6.47
6.65 6.83
6.51
6.68 6.87
6.490
6.665 6.850
10
THE COMPARATIVE ADVANTAGE ARGUMENT
? AAACorp
wants to borrow floating ? BBBCorp wants to borrow fixed
Fixed AAACorp BBBCorp 4.0% 5.2%
Floating 6-month LIBOR + 0.30% 6-month LIBOR + 1%
THE SWAP
3.95% 4% AAACorp
BBBCorp
LIBOR+1%
LIBOR
CRITICISM OF THE COMPARATIVE ADVANTAGE ARGUMENT
? The
4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates ? The LIBOR+0.3% and LIBOR+ 1% rates available in the floating rate market are sixmonth rates ? BBBCorp’s fixed rate depends on the spread above LIBOR it borrows at in the future
THE SWAP WHEN A FINANCIAL INSTITUTION IS INVOLVED
3.93%
4% AAACorp 3.97%
F.I .
BBBCorp LIBOR+1% LIBOR
LIBOR
THE NATURE OF SWAP RATES
? Six-month
LIBOR is a short-term AA borrowing rate ? The 5-year swap rate has a risk corresponding to the situation where 10 sixmonth loans are made to AA borrowers at LIBOR ? This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate
CURRENCY SWAPS
In an interest rate swap the principal is not exchanged ? In a currency swap the principal is usually exchanged at the beginning and the end of the swap’s life
?
SCENARIO
Dollars 4%
IBM
Sterling 7%
BP
THE CASH FLOWS(IBM PERSPECTIVE)
Year 2004 2005 2006 2007 2008 2009 Dollars Pounds $ £ ------millions-----–15.00 +10.00 +0.60 –0.70 +0.60 –0.70 +0.60 –0.70 +0.60 –0.70 +15.60 ?10.70
COMPARATIVE ADVANTAGE ARGUMENTS FOR CURRENCY SWAPS
General Motors wants to borrow 20 million AUD Qantas wants to borrow 12 million USD
USD General Motors Qantas 5.0% 7.0%
AUD 12.6% 13.0%
Total gains to the parties involved: (7-2) – (13.0-12.6) = 1.6%
COMPLETE PICTURE
USD 1.3% USD 5.0% USD 6.3%
GM
USD 5.0% AUD 11.9%
Financial institution
AUD 13.0% AUD 1.1%
Quantus Airways
AUD 13%
FURTHER COMPLICATIONS…
?
Cross Currency interest rate swaps : Combo of floating rate and Fixed rate.
?
A small firm might borrow $ from a local bank at a floating-rate and then use a cross-currency interest-rate swap to swap payments with a large firm that has issued fixed-rate bonds denominated in €.
?
Cross Currency Floating to floating currency swaps : Combo when both are Floating rates
?
A multinational firm with a loan in euros based on a short-term European interest rate can use a crosscurrency floating-to-floating swap to transform its € loan into a dollar loan on the prime rate.
CREDIT DEFAULT SWAP
Loan Corp (Reference Entity)
BANK OF CDS
Investor Co
Takes a Loan
Buys a CDS(5%)
SCENARIOS UNLEASHED…
In case of no credit event on associated credit instrument.
In case the associated credit instrument suffered a credit event.
BASIC CONCEPTS
CDS protection amount ? CDS Spread : Annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount ? CDS spreads will increase as credit-worthiness declines, and decline as credit-worthiness increases
?
CREDIT EVENT TRIGGERS
Loan default ? Restructuring ? Bankruptcy, ? Or having its credit rating downgraded.
?
doc_847502541.ppt
This is a presentation describes Swaps and discusses topics like cash flows, interest rate swaps, comparative advantage, currency swaps with the examples of Microsoft, IBM, BP, GM , Qantas
SWAPS
NATURE OF SWAPS
A swap is an agreement to exchange cash flows at specified future times according to certain specified rules
2
AN EXAMPLE OF A “PLAIN VANILLA” INTEREST RATE SWAP
? An
agreement by Microsoft to receive 6-month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million ? Next slide illustrates cash flows that could occur
CASH FLOWS TO MICROSOFT
---------Millions of Dollars--------LIBOR FLOATING Date Rate FIXED Net Cash Flow Cash Flow Cash Flow +2.10 –2.50 –0.40
Mar.5, 2004
Sept. 5, 2004
4.2%
4.8%
Mar.5, 2005
Sept. 5, 2005 Mar.5, 2006
5.3%
5.5% 5.6%
+2.40
+2.65 +2.75
–2.50
–2.50 –2.50
–0.10
+0.15 +0.25
Sept. 5, 2006
Mar.5, 2007
5.9%
6.4%
+2.80
+2.95
–2.50
–2.50
+0.30
+0.45
TYPICAL USES OF AN INTEREST RATE SWAP
?
Converting a liability from
? ?
fixed rate to floating rate floating rate to fixed rate
fixed rate to floating rate floating rate to fixed rate
?
Converting an investment from
? ?
INTEL AND MICROSOFT (MS) TRANSFORM A LIABILITY
5% 5.2%
Intel
LIBOR
MS
LIBOR+0.1%
FINANCIAL INSTITUTION IS INVOLVED
4.985% 5.2%
5.015%
Intel
LIBOR
F.I.
LIBOR
MS
LIBOR+0.1 %
Financial Institution has two offsetting swaps
INTEL AND MICROSOFT (MS) TRANSFORM AN ASSET
5%
4.7%
Intel
LIBOR-0.2% LIBOR
MS
FINANCIAL INSTITUTION IS INVOLVED
4.985%
5.015% 4.7%
Intel
LIBOR-0.2% LIBOR
F.I.
LIBOR
MS
QUOTES BY A SWAP MARKET MAKER
Maturity
2 years 3 years 4 years
Bid (%)
6.03 6.21 6.35
Offer (%)
6.06 6.24 6.39
Swap Rate (%)
6.045 6.225 6.370
5 years
7 years 10 years
6.47
6.65 6.83
6.51
6.68 6.87
6.490
6.665 6.850
10
THE COMPARATIVE ADVANTAGE ARGUMENT
? AAACorp
wants to borrow floating ? BBBCorp wants to borrow fixed
Fixed AAACorp BBBCorp 4.0% 5.2%
Floating 6-month LIBOR + 0.30% 6-month LIBOR + 1%
THE SWAP
3.95% 4% AAACorp
BBBCorp
LIBOR+1%
LIBOR
CRITICISM OF THE COMPARATIVE ADVANTAGE ARGUMENT
? The
4.0% and 5.2% rates available to AAACorp and BBBCorp in fixed rate markets are 5-year rates ? The LIBOR+0.3% and LIBOR+ 1% rates available in the floating rate market are sixmonth rates ? BBBCorp’s fixed rate depends on the spread above LIBOR it borrows at in the future
THE SWAP WHEN A FINANCIAL INSTITUTION IS INVOLVED
3.93%
4% AAACorp 3.97%
F.I .
BBBCorp LIBOR+1% LIBOR
LIBOR
THE NATURE OF SWAP RATES
? Six-month
LIBOR is a short-term AA borrowing rate ? The 5-year swap rate has a risk corresponding to the situation where 10 sixmonth loans are made to AA borrowers at LIBOR ? This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate
CURRENCY SWAPS
In an interest rate swap the principal is not exchanged ? In a currency swap the principal is usually exchanged at the beginning and the end of the swap’s life
?
SCENARIO
Dollars 4%
IBM
Sterling 7%
BP
THE CASH FLOWS(IBM PERSPECTIVE)
Year 2004 2005 2006 2007 2008 2009 Dollars Pounds $ £ ------millions-----–15.00 +10.00 +0.60 –0.70 +0.60 –0.70 +0.60 –0.70 +0.60 –0.70 +15.60 ?10.70
COMPARATIVE ADVANTAGE ARGUMENTS FOR CURRENCY SWAPS
General Motors wants to borrow 20 million AUD Qantas wants to borrow 12 million USD
USD General Motors Qantas 5.0% 7.0%
AUD 12.6% 13.0%
Total gains to the parties involved: (7-2) – (13.0-12.6) = 1.6%
COMPLETE PICTURE
USD 1.3% USD 5.0% USD 6.3%
GM
USD 5.0% AUD 11.9%
Financial institution
AUD 13.0% AUD 1.1%
Quantus Airways
AUD 13%
FURTHER COMPLICATIONS…
?
Cross Currency interest rate swaps : Combo of floating rate and Fixed rate.
?
A small firm might borrow $ from a local bank at a floating-rate and then use a cross-currency interest-rate swap to swap payments with a large firm that has issued fixed-rate bonds denominated in €.
?
Cross Currency Floating to floating currency swaps : Combo when both are Floating rates
?
A multinational firm with a loan in euros based on a short-term European interest rate can use a crosscurrency floating-to-floating swap to transform its € loan into a dollar loan on the prime rate.
CREDIT DEFAULT SWAP
Loan Corp (Reference Entity)
BANK OF CDS
Investor Co
Takes a Loan
Buys a CDS(5%)
SCENARIOS UNLEASHED…
In case of no credit event on associated credit instrument.
In case the associated credit instrument suffered a credit event.
BASIC CONCEPTS
CDS protection amount ? CDS Spread : Annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount ? CDS spreads will increase as credit-worthiness declines, and decline as credit-worthiness increases
?
CREDIT EVENT TRIGGERS
Loan default ? Restructuring ? Bankruptcy, ? Or having its credit rating downgraded.
?
doc_847502541.ppt