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1 Admin News Final’s date: 60% liked 12/18 (Registrar-set date). => So, final will be 12/18. Some of you had emergency reasons & wound not be able to make it => expect an email from me. Quiz V next Tuesday… If absolutely can’t come, please let me know… Will try to accommodate you. Otherwise, weight goes to final

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2 Swaps (or parts of chapter 14)

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3 Agenda Interest rate risk? Credit & Repricing risks What hedging strategy? Refinancing Forward Rate Agreement Interest Rate Future Interest Rate Swap Currency Swap (& how to undo them) Counterparty Risk Cross Currency Swaps (again )

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4 Interest Rate Risk Fact: all firms sensitive to interest rate changes. MNE: differing currencies have differing interest rates => interest rate risk larger! Reference rate rate of interest used in standardized quotation, loan agreement, or financial derivative valuation Most common: LIBOR (London Interbank Offered Rate).

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5 Credit and Repricing Risk Credit (roll-over ) Risk: risk of change of borrower creditworthiness when renewing credit. Repricing risk: risk of changes in interest rates charged (earned) when financial contract rate is reset. For Example: three debt strategies #1: Borrow $1 million for 3 years @ fixed rate. #2: Borrow $1 million for 3 years @ floating rate, LIBOR + 2% reset annually. #3: Borrow $1 million for 1 year @ fixed rate, renew credit annually

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6 How to hedge floating-rate loans risk? Assume floating-rate loan for US$10 m. Serviced w/ annual payments Bullet principal payment @ end third year Loan priced @ US$ LIBOR + 1.50%. LIBOR reset annually. At time 0, up-front fee of 1.50%. Do we know the actually cost?

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7 Floating-Rate Loan: Example

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8 How to manage a floating rate loan? Alternatives Refinancing –refinance the entire agreement. Forward Rate Agreement (FRA) –lock in future interest rate payment (as w/ forex forward contracts). Interest Rate Futures Interest Rate Swaps –Could swap floating rate note for fixed rate note w/ swap dealer.

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9 Forward Rate Agreement (FRA) Interbank-traded contract to buy or sell interest rate payments on notional principal. E.g.: If you wish to lock in first payment, buy a FRA which locks total interest payment @ 6.5% –If LIBOR above 5% => receive cash payment from FRA seller reducing LIBOR payment to 5% –If LIBOR below 5% => pay FRA seller cash amount increasing LIBOR payment to 5% –So you locking in payment of 5%+1.5%!

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10 Interest Rate Futures Very often used (unlike forex futures) high liquidity of interest rate futures markets standardized interest rate exposures firms Exchange-traded Chicago Mercantile Exchange (CME). Chicago Board of Trade (CBOT). London Intl Financial Futures & Options Exchange (LIFFE). Yield calculated from settlement price ExposureActionInterest Rate Outcome Paying interest Short future Rates up Rates down P futures down (short: profit) P futures up (short: loss) Earning interest Long future Rates up Rates down P futures down (long: loss) P futures up (long: profit)

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11 Eurodollar Futures (3 month), 11/19/03 Source: WSJ, 11/20/03

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12 Interest Rate & Currency Swaps Contractual agreements to exchange (swap) series of cash flows. Commits each counterparty to exchange amount of funds, @ regular intervals, until expiration. Interest rate swap: agreement to swap fixed interest payment for floating rate payment. Currency swap: agreement to swap currencies of debt service => initial currency exchange & reverse @ maturity. Swap may combine elements of both interest rate and currency swap. Swap itself not source of capital!

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13 Interest Rate Swaps Strategies Swap = collection of forward contracts for exchange of funds @specified maturities. reduces transaction costs. legal structure of swap transaction reduce counterparty risk. Interest rate swap cash flows: interest rates applied to a notional principal, but no principal is swapped! PositionExpectationStrategy Fixed-Rate DebtRates up Rates down Stay put Pay floating/Receive Fixed Floating-Rate DebtRates up Rates down Pay fixed/Receive floating Stay put

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14 Example: swapping to fixed rates Expect rates will rise over life of loan. => interest rate swap pay fixed/receive floating would be best. Bank quotes you 5.75% against LIBOR The swap does not replace the original loan, must still make payments at original rates! Swap only supplements the loan payments!

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15 Interest Rate Swap

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16 Currency Swap So far, raised $10m in floating rate financing & swap into fixed rate payments. But, may prefer to make debt-service payments in SF. => would enter into a 3-year pay Swiss francs & receive US$ swap Both interest rates fixed. Will pay 2.01% (ask rate) fixed SF interest & receive 5.56% (bid rate) fixed US$. Spot rate on date of agreement establishes notional principal is in target currency Notional amount of SF 15,000,000. Commit to payments SF 301,500 (2.01% SF15,000,000) The notional amounts part of swap agreement!

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17 Currency Swap Source: Financial Times (as quoted by MSE)

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18 Swapping US$ to Swiss Francs

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19 Unwinding Swaps Can unwind a swap if viewpoints changes… Assume 3-year contract w/ Swiss buyer terminates in one year How to unwind it? Discount remaining cash flows under swap agreement @ current interest rates. Convert target currency back to home currency

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20 Unwinding Swaps Assume two payments left: SF301,500 & SF15,301,500 2-year fixed rate for SF is 2% PV swap commitment PV of remaining cash flows on the $-side of swap is determined using current 2 year fixed dollar rate 5.5% PV net inflows $10,011,078. PV net outflows SF 15,002,912. If current spot SF 1.465/$ net settlement

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21 Counterparty Risk Potential exposure any firm bears that second party to financial contract will be unable to fulfill obligations. A firm entering into a swap agreement retains the ultimate responsibility for its debt-service. In event swap counterpart defaults, payments would cease. The real exposure: not total notional principal, but mark-to-market value of differentials!

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22 3-way Cross Currency Swap Province of Ontario (Canada) Borrows $390 m @ US Treasury + 48 b.p. Finish Export Credit (Finland) Borrows C$300 million @ Canadian Treasury + 47 b.p. Inter-American Development Bank Borrows C$150 million @ Canadian Treasury + 44 b.p. $260 million C$300 million $130 million C$150 million Sometimes firms enter into loan agreements w/ swap already in mind, creating debt issuance coupled w/ swap from inception…

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23 Things to remember… Interest rate risk? Credit & Repricing risks What hedging strategy? Refinancing Forward Rate Agreement Interest Rate Future Interest Rate Swap Currency Swap (& how to undo them) Counterparty Risk. Cross Currency Swaps.

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Chapter 8 Interest Rate Derivatives (Textbook Chapter 9)

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