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Copyright 1999 A.S. Cebenoyan1 C15.0021 Money, Banking, and Financial Markets Professor A. Sinan Cebenoyan NYU-Stern-Finance.

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Presentation on theme: "Copyright 1999 A.S. Cebenoyan1 C15.0021 Money, Banking, and Financial Markets Professor A. Sinan Cebenoyan NYU-Stern-Finance."— Presentation transcript:

1 Copyright 1999 A.S. Cebenoyan1 C Money, Banking, and Financial Markets Professor A. Sinan Cebenoyan NYU-Stern-Finance

2 Copyright 1999 A.S. Cebenoyan2 Interest-Rate Swap Example (borrowed from Katerina Simons, New England Economic Review, 1989) 3 Parties involved: –A Public Utility (BBB rated) –A Finance Company (AAA rated) –A Bank (AA rated) Starting Positions: –Utility: has low credit rating. Wants to match its LT assets with LT fixed-rate debt. But finds it expensive –Finance Co: has good rating. Can obtain low cost fixed rate debt, but prefers ST or floating to match ST assets.

3 Copyright 1999 A.S. Cebenoyan3 Bank serves as middleman Borrowing costs before swap (%): Fixed RateFloating Rate Public Utility 10.00LIBOR +.80 Finance Co LIBOR +.30 difference The finance co. enjoys a lower borrowing cost in both markets. But, the public utility faces relatively lower costs in floating rate mkt. It has a comparative advantage of 65 bp ( ). This 65 bp comp. Advantage is the amount of potential savings from the swap.

4 Copyright 1999 A.S. Cebenoyan4 Public Utility (BBB) Bank (AA) Finance Company (AAA) Pays 9% fixed Pays 8.9% fixd LIBOR Borrows floating LIBOR +.80 Borrows fixed 8.85 % Public Utility pays bank fixed 9% and receives LIBOR. Its Total Borrowing costs are: 9% - LIBOR + ( LIBOR +.80 ) = 9.8%

5 Copyright 1999 A.S. Cebenoyan5 Finance Company pays Bank LIBOR and receives 8.9% fixed. Its Total borrowing costs are: LIBOR - 8.9% % = LIBOR % In Summary: Public UtilityFinance Company Pays 9%Pays LIBOR -Receives LIBOR-Receives 8.9% Borrows LIBOR +.80Borrows 8.85% 9.8% LIBOR -.05% Cost w/o swap 10.0% LIBOR +.30% SAVINGS.20 %.35%

6 Copyright 1999 A.S. Cebenoyan6 Total Potential savings from swap were.65%. The bank takes.10 % spread as compensation for the swap. Note: The parties have not exchanged obligations to make principal payments, only to make each other’s interest payments. Hedges may not be perfect This is a simple example to display the mechanics of a swap. It does not go into risks, and exposures to the parties involved. Interest rate movements and credit risks are very important.


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