©David Dubofsky and 12-1 Thomas W. Miller, Jr. Chapter 12 Using Swaps to Manage Risk Swaps can be used to lower borrowing costs and generate higher investment returns. Swaps can be used to transform floating rate assets into fixed rate assets, and vice versa. Swaps can transform floating rate liabilities into fixed rate liabilities, and vice versa. Swaps can transform the currency behind any asset or liability into a different currency.

©David Dubofsky and 12-2 Thomas W. Miller, Jr. Swapping to Lower Borrowing Costs, I. Two firms can enter into a plain vanilla swap to exploit their comparative advantages regarding quality spread differentials. For example: –Firm B is a low-rated, risky, firm. It can borrow at a fixed rate of 8%, or at a floating rate of LIBOR + 75bp. –Potential counter-party, Firm A, can borrow at a fixed rate of 7%, or at a floating rate of LIBOR +25bp.

©David Dubofsky and 12-3 Thomas W. Miller, Jr. Swapping to Lower Borrowing Costs, II. Suppose Firm B wishes to borrow at a fixed rate, and Firm A wishes to borrow at a variable rate. Although B faces higher rates in both markets, it has a comparative advantage in the floating rate market. –It is paying only 50bp more in the floating rate market, but it must pay 100bp more in the fixed rate market. Firm A has a comparative advantage in the fixed rate market because –Firm A is paying 100 bp less there, compared to 50 bp less in the floating rate market.

©David Dubofsky and 12-4 Thomas W. Miller, Jr. Swapping to Lower Borrowing Costs, III. Capital Market pays floating LIBOR + 75bp Firm B Firm A Fixed at 7.1% Floating at LIBOR THE SWAP borrows NP at a fixed rate pays fixed rate of 7% borrows NP at a variable rate Net result: Firm B has borrowed at a fixed rate of 7.85%, and Firm A has borrowed at a floating rate equal to LIBOR - 10bp. Both counter-parties to this swap have lowered their interest expense by swapping.

©David Dubofsky and 12-5 Thomas W. Miller, Jr. Swapping to Lower Borrowing Costs, IV. The gains to these types of swaps (that lower borrowing costs) have diminished in recent years, but judging from surveys on derivatives usage, the gains still exist. These swaps are done with swap dealers (intermediaries); firms don’t do them between themselves. Firm B Swap Dealer Firm A 7.12% fixed7.08% fixed Floating LIBOR

©David Dubofsky and 12-6 Thomas W. Miller, Jr. Using a Swap to Transform Liabilities: Party A is hedging against rising interest rates ; Party B will then benefit from falling interest rates B LIBOR 5% 6% LIBOR A ‘B’ has an existing fixed rate loan ‘A’ has an existing floating rate loan The Swap The result (with the swap) is that A will be paying 5% fixed. B will be paying LIBOR bp.

©David Dubofsky and 12-7 Thomas W. Miller, Jr. Using a Swap to Transform Assets: Party A is locking in a fixed rate of return ; Party B will benefit from rising interest rates B LIBOR 5% 6% LIBOR A ‘B’ owns an existing fixed coupon bond ‘A’ owns an existing floating rate bond The Swap The result (with the swap) is that A will be receiving 5% fixed. B will be receiving LIBOR bp.

©David Dubofsky and 12-8 Thomas W. Miller, Jr. Using a Currency Swap to Hedge Against an increase in the Price of a Foreign Currency Transform a liability in one currency into a liability in another currency. Transform an expense (cost) in one currency into a another currency. ¥ ¥ $ Before the swap, this U.S. firm loses if the $/ ¥ exchange rate rises.

©David Dubofsky and 12-9 Thomas W. Miller, Jr. Using a Currency Swap to Hedge Against a Decrease in the Price of a Foreign Currency Transform an investment in one currency into an asset in another currency. Transform a revenue in one currency into a another currency. € $ € Before the swap, this U.S. firm loses if the $/€ exchange rate falls.

©David Dubofsky and Thomas W. Miller, Jr. Comparative Advantage for Currency Swaps Two firms can enter into a currency swap to exploit their comparative advantages regarding borrowing in different countries. That is, suppose: –Firm B can borrow in $ at 8.0%, or in € at 6.0%. –Firm A can borrow in $ at 6.5% or in € at 5.2%. If A wants to borrow €, and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.

©David Dubofsky and Thomas W. Miller, Jr. Using Commodity Swaps: Examples An airline wants to lock in the price it pays for ‘x’ gallons of jet fuel per quarter. –In each of the next N years, the airline will agree to pay a fixed price and receive the floating price. A gold producer wants to lock in the price it receives for ‘z’ oz. of gold each month. –In each of the next M years, the gold producer will agree to pay a floating price and receive a fixed price.

©David Dubofsky and Thomas W. Miller, Jr. Using Equity Swaps: Examples A bearish portfolio manager might agree to pay, each month, the monthly rate of return on a portfolio of stocks, and receive a floating rate of return linked to LIBOR (divided by 12), receive a fixed payment. Note if the portfolio of stocks declines in value, the portfolio manager actually receives two cash flows!