1. Prof. Ian Giddy New York University Swap Financing Techniques SIM/NYU The Job of the CFO

2. Copyright ©2001 Ian H. Giddy Swap Financing 2 giddy.org Interest Rate and Currency Swaps l Mechanics of swaps l Valuation of swaps l Credit risk of swaps l Pricing swaps l Hedging swaps l The all-in cost of swap financing l Currency swaps vs forwards

3. Copyright ©2001 Ian H. Giddy Swap Financing 3 giddy.org Swaps: Mechanics and Valuation IC&Tel CIBC Fixed ECU 7% Floating ECU Libor Periodic exchanges of interest payments are made during the life of the swap. Remember that the principal amount is not exchanged

4. Copyright ©2001 Ian H. Giddy Swap Financing 4 giddy.org Interest-Rate Swap Example CIBC AA IC&Tel BBB Fixed 5.00%Floating 6-Month LIBOR + 25 Payments to Capital Markets Payments to Capital Markets

5. Copyright ©2001 Ian H. Giddy Swap Financing 5 giddy.org Interest-Rate Swap Example Exchange of Interest Payments Every 6 Mo Fixed 5.50% Floating 6-Month LIBOR Flat Fixed 5.00%Floating 6-Month LIBOR + 25 Payments to Capital Markets Payments to Capital Markets AABBB CIBCIC&Tel

6. Copyright ©2001 Ian H. Giddy Swap Financing 6 giddy.org Interest-Rate Swap Example Exchange of Interest Payments Every 6 Mo Fixed 5.50% Floating 6-Month LIBOR Flat Fixed 5.00%Floating 6-Month LIBOR + 25 Cost of Funds After Swap: - Pay fixed 5.50% - Receive LIBOR Flat - Pay LIBOR + 25 - Net Cost: 5.75% Fixed Cost of Funds After Swap: - Pay 5.00% fixed - Receive 5.50% fixed - Pay 6-month LIBOR Flat - Net Cost: 6-month LIBOR - 50 Payments to Capital Markets Payments to Capital Markets AABBB CIBCIC&Tel

7. Copyright ©2001 Ian H. Giddy Swap Financing 7 giddy.org Swap Quotation Screen

8. Copyright ©2001 Ian H. Giddy Swap Financing 8 giddy.org A Currency Swap FMC BANK GBP 100 USD 150 Company issues dollar debt, but wants sterling financing so exchanges its dollars for sterling equivalent at today’s spot exchange rate USD 150

9. Copyright ©2001 Ian H. Giddy Swap Financing 9 giddy.org Periodic Exchange of Interest FMC BANK GBP 100 USD 150 FMC BANK Fixed GBP 12% Floating USD Libor s.a.

10. Copyright ©2001 Ian H. Giddy Swap Financing 10 giddy.org Three Parts of a Currency Swap FMC BANK GBP 100 USD 150 FMC BANK Fixed GBP 12% Floating USD Libor s.a. FMC BANK GBP 100 USD 150

11. Copyright ©2001 Ian H. Giddy Swap Financing 11 giddy.org l Valuation l Off-market swaps l Cancellation l Counterparty exposure l Hedging swap positions Swaps: Applications of Valuation BONDBOND FRN ABB BVB Fixed ECU 7% Floating ECU Libor

12. Copyright ©2001 Ian H. Giddy Swap Financing 12 giddy.org Valuation of an Interest Rate Swap Valuation of the swap is based on discounting the cash flows over its life. VALUE OF INTEREST RATE SWAP PRICE OF BOND WITH N YEARS TO RUN PRICE OF MONEY MARKET INSTRUMENT WITH M DAYS TO RUN =- A RECEIVE-FIXED, PAY-FLOATING SWAP:

13. Copyright ©2001 Ian H. Giddy Swap Financing 13 giddy.org Labatt’s Bank Fixed USD 9% Floating USD Libor s.a. Swap Valuation The value of a swap equals the "net worth" of the swap cash flows expressed as a balance sheet

14. Copyright ©2001 Ian H. Giddy Swap Financing 14 giddy.org At Inception, Standard Swap is Worth Zero

15. Copyright ©2001 Ian H. Giddy Swap Financing 15 giddy.org Two Years Later, Rates Have Fallen...

16. Copyright ©2001 Ian H. Giddy Swap Financing 16 giddy.org Swap Valuation Spreadsheet (This Uses the Zero-Coupon Approach)

17. Copyright ©2001 Ian H. Giddy Swap Financing 17 giddy.org Termination of Swaps l Basic principle: cancel or neutralize all future swap cash flows l What are the alternative ways in which this can be done?  Offsetting swap with same counterparty  Offsetting swap with new counterparty  Cancel swap  Reassign swap.

18. Copyright ©2001 Ian H. Giddy Swap Financing 18 giddy.org Default Risk in Swaps l In-the-money swaps entail credit risk—the value of the swap is the amount owed l At initiation, credit risk exposure is based on the potential value of the swap, which depends on potential changes in interest rates and currencies l Credit risk can be mitigated by collateralization and by netting of bilateral exposure.

19. Copyright ©2001 Ian H. Giddy Swap Financing 19 giddy.org How Swaps are Quoted

20. Copyright ©2001 Ian H. Giddy Swap Financing 20 giddy.org Swap Spreads are Tied to TED Spreads Treasury bonds Treasury bills Swap spread Interest rate swaps +=

21. Copyright ©2001 Ian H. Giddy Swap Financing 21 giddy.org Swap Spreads are Tied to TED Spreads Treasury bonds Treasury bills TED spread Swap spread Interest rate swaps FRAs and futures + + = = LONG TERM SHORT TERM

22. Copyright ©2001 Ian H. Giddy Swap Financing 22 giddy.org Swap Spreads are Tied to TED Spreads Treasury bonds Treasury bills TED spread Swap spread Interest rate swaps Corporate bonds FRAs and futures Libor: E$ market + + = = LONG TERM SHORT TERM

23. Copyright ©2001 Ian H. Giddy Swap Financing 23 giddy.org FRAs and Friends l FRA: A contract to lock in a rate for a future period l Futures: A daily recontracted FRA l Swap: A strip of FRAs at a blended rate

24. Copyright ©2001 Ian H. Giddy Swap Financing 24 giddy.org Estimating the Cost of Funds in a Swap Problem: Convert existing 4 year floating rate dollar sub- LIBOR funds into fixed rate sterling funds. Pay sterling fixed annually; receive dollar floating semi-annually. What is the all-in sterling cost? Swap Quote Indication Sheet Swap Quote: Standard four year sterling/dollar swap quote would be sterling 11.90-12.00 against 6 month $ LIBOR flat. If client wants a non-standard swap such as sterling fixed against 6-month $ LIBOR-25, bank might quote: “You pay sterling 11.73% annual, we pay 6-mo LIBOR less 25."

25. Copyright ©2001 Ian H. Giddy Swap Financing 25 giddy.org A Standard Currency Swap FMC BANK GBP 100 USD 150 FMC BANK Fixed GBP 12% Floating USD Libor s.a. FMC BANK GBP 100 USD 150

26. Copyright ©2001 Ian H. Giddy Swap Financing 26 giddy.org FMC BANK Fixed GBP 12% Floating USD Libor s.a. Estimating the Cost of Funds in a Swap Fixed GBP 11.73% Floating USD Libor s.a. -0.25% Floating USD Libor -0.25%

27. Copyright ©2001 Ian H. Giddy Swap Financing 27 giddy.org Basis Point Conversion: The quote of Sterling 11.73% annual fixed payments against LIBOR - 25 required conversion from dollar basis points to sterling basis points. How to do this: 1.Find present value of 25 U.S. dollar basis points paid semi-annually at 8.77% interest. 2.Find the sterling annuity equivalent of 82.84 at the sterling swap rate of 12.00% paid annually. Annuity value of 82.84 @ 12% [annual] = 27.27bp GBP Estimating the Cost of Funds in a Swap

28. Copyright ©2001 Ian H. Giddy Swap Financing 28 giddy.org l Kalamazoo needs $60 million. l Receiving Euro, the European Currency unit. Whose Zoo? l K’zoo could borrow five-year money at semi-annual LIBOR + 3/4%, and Dresdner agreed to enter into a currency swap with the company.  Diagram the swap with little boxes.  What would K’zoo's cost of capital be if it did the swap? (US 5-yr swap rate = 10%)  Effect of a rise in ST & LT rate?  How would a 0.75% up front commitment fee affect K’zoo's cost of capital?

29. Copyright ©2001 Ian H. Giddy Swap Financing 29 giddy.org Kalamazoo K’ZOO DRESDNER Fixed ECU 8.35% Floating USD Libor s.a. Fixed EURO 8.35+0.73%=9.08% Floating USD Libor +0.75% Floating USD Libor +0.75% l 75bpUSD=73bpEuro; swapped cost is 9.08% l ST rate: no effect. LT rate rise: value of swap will change by duration. K’zoo gains, Dresdner loses. l Amortize the up-front fee of 0.75% over the period of the financing, and add it to swapped cost.. Euro revenues

30. Copyright ©2001 Ian H. Giddy Swap Financing 30 giddy.org BP Conversion: Excel Spreadsheet

31. Copyright ©2001 Ian H. Giddy Swap Financing 31 giddy.org INVESTOR Asset Swaps: The Same Idea Fixed GBP 12.73% l Investor buys cheap fixed-rate bond l But wants a floating-rate note.

32. Copyright ©2001 Ian H. Giddy Swap Financing 32 giddy.org INVESTOR BANK Fixed GBP 12% Floating USD Libor s.a. Asset Swaps: The Same Idea Fixed GBP 12.73% Floating USD Libor s.a. +0.75% Fixed GBP 12.73%

33. Copyright ©2001 Ian H. Giddy Swap Financing 33 giddy.org Currency Swaps vs Long-dated Forwards SF £ £ LONG-DATED FORWARD SPOT RATE End-period exchange occurs at forward rate, which represents the spot rate plus the cumulative interest tate differential. FORWARD RATE

34. Copyright ©2001 Ian H. Giddy Swap Financing 34 giddy.org Currency Swaps vs Long-dated Forwards SF ££ ££ LONG-DATED FORWARDCURRENCY SWAP SPOT RATE SPOT RATE PERIODIC INTEREST RATE DIFFERENTIAL End-period exchange occurs at forward rate, which represents the spot rate plus the cumulative interest tate differential. End-period exchange occurs at spot rate, since the cumulative interest tate differential is paid during interim periods. FORWARD RATE SPOT RATE

35. Copyright ©2001 Ian H. Giddy Swap Financing 35 giddy.org A Basis Swap Fuji Bank Fuji Bank Citi Fuji makes a loan at Prime + Spread, but gets funding in the Eurodollar interbank market Prime + Spread Floating Libor

36. Copyright ©2001 Ian H. Giddy Swap Financing 36 giddy.org A Basis Swap Fuji Bank Fuji Bank Citi Prime Floating Libor Fuji makes a loan at Prime + Spread, but gets funding in the Eurodollar interbank market Fuji wants to lock in its spread, so does a basis swap with Citibank Prime + Spread Floating Libor

37. Copyright ©2001 Ian H. Giddy Swap Financing 37 giddy.org Basis Swap Quotations

38. Copyright ©2001 Ian H. Giddy Swap Financing 38 giddy.org A Basis Swap Fuji Bank Fuji Bank Citi Prime-263 Floating 3-mo Libor Fuji makes a 3-year loan at Prime + 1%, and swaps at P-2.63% Fuji thus locks in a spread of 3.63% Prime + 1% Floating Libor flat

39. Copyright ©2001 Ian H. Giddy Swap Financing 39 giddy.org Commodity Swap Example: Qantas QANTAS US$ LIBOR +1/4% SEMIIANNUAL PASSENGER REVENUES FUEL COSTS

40. Copyright ©2001 Ian H. Giddy Swap Financing 40 giddy.org Example: Qantas QANTAS PARIBAS US$ LIBOR +1/4% SEMIIANNUAL PASSENGER REVENUES FUEL COSTS

41. Copyright ©2001 Ian H. Giddy Swap Financing 41 giddy.org Example: Qantas QANTAS PARIBAS US$ LIBOR +1/4% SEMIIANNUAL US$ FIXED 10% +/- $30 M X (1-%CH AW INDEX) US$ LIBOR +1/4% SEMIIANNUAL

42. Copyright ©2001 Ian H. Giddy Swap Financing 42 giddy.org Summary l Mechanics of swaps l Valuation of swaps l Credit risk of swaps l Pricing swaps l Hedging swaps l The all-in cost of swap financing l Swap around the clock

43. Copyright ©2001 Ian H. Giddy Swap Financing 43 giddy.org

44. Copyright ©2001 Ian H. Giddy Swap Financing 44 giddy.org Ian H. Giddy Stern School of Business New York University 44 West 4th Street, New York, NY 10012, USA Tel 212-998-0332 Fax 917-463-7629 ian.giddy@nyu.edu http://giddy.org