1. S W A P Adler Haymans Manurung Direktur Fund Management PT Nikko Securities Indonesia

2. 2 Nature of Swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

3. 3 Swap Currency Swap Interest Rate Swap

4. 4 Typical Uses of an Interest Rate Swap Converting a liability from –fixed rate to floating rate –floating rate to fixed rate Converting an investment from –fixed rate to floating rate –floating rate to fixed rate

5. 5 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, transaction date March 5 th, 2004. Next slide illustrates cash flows

6. 6 ---------Millions of Dollars--------- LIBORFLOATINGFIXEDNet DateRateCash Flow Mar.5, 20044.2% Sept. 5, 20044.8%+2.10–2.50–0.40 Mar.5, 20055.3%+2.40–2.50–0.10 Sept. 5, 20055.5%+2.65–2.50+0.15 Mar.5, 20065.6%+2.75–2.50+0.25 Sept. 5, 20065.9%+2.80–2.50+0.30 Mar.5, 20076.4%+2.95–2.50+0.45 Cash Flows to Microsoft

7. 7 Microsoft and Intel IntelMicrosoft LIBOR 5% Notional principal – did not exchange

8. 8 ---------Millions of Dollars--------- LIBORFLOATINGFIXEDNet DateRateCash Flow Mar.5, 20044.2% Sept. 5, 20044.8%+2.10–2.50–0.40 Mar.5, 20055.3%+2.40–2.50–0.10 Sept. 5, 20055.5%+2.65–2.50+0.15 Mar.5, 20065.6%+2.75–2.50+0.25 Sept. 5, 20065.9%+2.80–2.50+0.30 Mar.5, 20076.4%+102.95–102.50+0.45 Cash Flows to Microsoft

9. 9 Swap to Transform Liability Microsoft has arranged to borrow US$ 100 million at LIBOR plus 10 bps Microsoft –It pays LIBOR plus 0.1% to outside lenders –It receives LIBOR under the terms of the swap –It pays 5% under the term of the swap Intel has a 3-year $ 100 million loan outstanding on which it pays 5.2%. Intel –It pays 5.2% to outside lenders –It pays LIBOR under the terms of the swap –It receives 5% under the term of the swap

10. 10 Intel and Microsoft (MS) Transform a Liability LIBOR 5% LIBOR+0.1% 5.2% Intel Micrsoft

11. 11 Swap to Transform Assets Microsoft owns US$ 100 million in bonds that will provide interest at 4.7% pa over the next 3 years Microsoft –It receives 4.7% on the bonds. –It receives LIBOR under the terms of the swap –It pays 5% under the term of the swap Intel has investment of US$ 100 million that yields LIBOR minus 20 bps. Intel –It receives LIBOR minus 20 bps on its investment –It pays LIBOR under the terms of the swap –It receives 5% under the term of the swap

12. 12 Intel and Microsoft (MS) Transform a Asset LIBOR 5% LIBOR - 0.2% 4.7% Intel Micrsoft

13. 13 Through Intermediary FI Financial Institution as intermediary among parties Financial institution earns about 3 or 4 basis point (0.03% to 0.04%) on a pair of offsetting transactions Microsoft ends up borrowing at 5.115% Intel ends up borrowing at LIBOR plus 21.5 bps.

14. 14 Financial Institution is Involved LIBOR LIBOR+0.1% 4.985% 5.015% 5.2% Intel Microsoft F I

15. 15 Financial Institution is Involved LIBOR LIBOR+0.1% 4.985% 5.015% 5.2% Intel Microsoft F I

16. 16 Quotes By a Swap Market Maker MaturityBid (%)Offer (%)Swap Rate (%) 2 years6.036.066.045 3 years6.216.246.225 4 years6.356.396.370 5 years6.476.516.490 7 years6.656.686.665 10 years6.836.876.850

17. 17 The Comparative Advantage Argument Two companies wish to borrow $10 million for 5 years AAACorp has a AAA credit rating BBBCorp has a BBB credit rating AAACorp wants to borrow floating BBBCorp wants to borrow fixed See Table below FixedFloating AAACorp4.0%6-month LIBOR + 0.30% BBBCorp5.20%6-month LIBOR + 1.00% AAACorp has comparative advantage in fixed-rate markets BBBCorp has comparative advantage in floating-rate markets

18. 18 The Swap AAACorp BBBCorp LIBOR LIBOR+1% 3.95% 4%

19. 19 The Swap when a Financial Institution is Involved AAACorp F.I. BBBCorp 4% LIBOR LIBOR+1% 3.93% 3.97%

20. 20 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 six- month rates BBBCorp’s fixed rate depends on the spread above LIBOR it borrows at in the future

21. 21 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 six-month 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

22. 22 Valuation of an Interest Rate Swap that is not New Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)

23. 23 Valuation in Terms of Bonds The fixed rate bond is valued in the usual way The floating rate bond is valued by noting that it is worth par immediately after the next payment date

24. 24 Valuation in Terms of FRAs Each exchange of payments in an interest rate swap is an FRA The FRAs can be valued on the assumption that today’s forward rates are realized

25. 25 Exchange of Principal 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

26. 26 Typical Uses of a Currency Swap Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency

27. 27 An Example of a Currency Swap An agreement to pay 7% on a sterling principal of £10,000,000 & receive 4% on a US$ principal of $15,000,000 every year for 5 years HP IBM Dollars 4% Sterling 7% Fixed to Fixed Currency Swap, because the interest rate is fixed

28. 28 The Cash Flows Year DollarsPounds $ ------millions------ 2004 –15.00 +10.00 2005 +0.60 –0.70 2006 +0.60 –0.70 2007 +0.60 –0.70 2008 +0.60 –0.70 2009+15.60−10.70 £

29. 29 Comparative Advantage Arguments for Currency Swaps General Motors wants to borrow AUD Qantas wants to borrow USD USDAUD General Motors 5.0%12.6% Qantas 7.0%13.0%

30. 30 Currency Swap motivated by Comparative Advantage AUD 11.9%AUD 13% USD 6.3%USD 5% General Motors F I Qantas Airways GM is 0.7% pa better off than it would be if it went directly to AUD Markets Qantas exchanges an AUD loan at 13% pa for USD loan at 6.3% pa and ends up 0.7% pa better off than it would be if it went directly to USD Markets. Financial Institutions gains 1.3% pa on its USD cash flows and loses 1.1% pa on its AUD flows.

31. 31 Valuation of Currency Swaps Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts

32. 32 Swaps & Forwards The value of the swap is the sum of the values of the forward contracts underlying the swap Swaps are normally “at the money” initially –This means that it costs nothing to enter into a swap –It does not mean that each forward contract underlying a swap is “at the money” initially

33. 33 Credit Risk A swap is worth zero to a company initially At a future time its value is liable to be either positive or negative The company has credit risk exposure only when its value is positive

34. 34 Other Types of Swaps Floating-for-floating interest rate swaps, amortizing swaps, step up swaps, forward swaps, constant maturity swaps, compounding swaps, LIBOR-in-arrears swaps, accrual swaps, diff swaps, cross currency interest rate swaps, equity swaps, extendable swaps, puttable swaps, swaptions, commodity swaps, volatility swaps……..