1. Hedging Financial Market Exposure Interest Rate Swaps Cross Currency Interest Rate Swaps

2. 2 What is a Derivative?? “A contract or security, whose value is derived from the price or level changes in some other underlying security, index or other instrument.” - Wall Street Journal definition. A separate financial contract which alters one’s exposure to future changes in: interest rates, equity security prices, commodity prices or foreign exchange rates.

3. 3 Interest Rate Swaps

4. 4 Floating Rates of Interest: PRIME: “The base rate on corporate loans posted by at least 75% of the nations 30 largest banks.” The PRIME rate is subject to change on a daily basis.

5. 5 Interest Rate Swaps Floating Rates of Interest: LIBOR: (London Interbank Offered Rate) “British Bankers Association average of interbank offered rates for dollar deposits in the London market based on quotations at 16 major banks.” The LIBOR rate is available for 1, 2, 3, 4, 5, 6 and 12 month maturity’s.

6. 6 Interest Rate Swaps

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9. 9 ABCPNC Bank Libor + 2.00%

10. 10 Interest Rate Swaps PNC Capital Markets ABC PNC Bank Libor + 2.00% Libor Swap Rate: 5.50%

11. 11 Interest Rate Swaps Swap Details: Notional Amount:$1,000,000 Start Date:August 7, 2001 Maturity Date:August 7, 2006 Amortization:$0 (bullet amortization) ABC Pays:5.50% Swap Rate, Quarterly, Actual/360 ABC Receives:Libor, Quarterly, Actual/360

12. 12 Interest Rate Swaps

13. 13 ABCBondholder Fixed Coupon: 7.25% Interest Rate Swaps

14. 14 PNC Capital Markets ABC Bondholder Fixed Coupon: 7.25% Libor + 1.75% Swap Rate: 7.25% Interest Rate Swaps

15. 15 Assess bank market versus corporate bond market/private placement market. Issue debt in the market which has a “comparative advantage” in terms of spreads, covenants, etc. Use Swaps and/or Reverse Swaps to implement the Fixed versus Floating strategy. Interest Rate Swaps

16. 16 Cross Currency Interest Rate Swaps

17. 17 Cross Currency Interest Rate Swaps ABC has an opportunity to make a direct investment in Europe, utilizing EURO as the currency. The “Investment” may consist of hard assets (real estate/equipment) or an operating company.

18. 18 Cross Currency Interest Rate Swaps ABC Euro EURO Investment Principal Cashflows Interest Cashflows Bank of Euro

19. 19 Cross Currency Interest Rate Swaps Unfortunately for ABC, it is unable to raise EURO denominated financing from a European bank.

20. 20 Cross Currency Interest Rate Swaps Principal Cashflows Interest Cashflows Loan Request ABC Euro EURO Investment Bank of Euro

21. 21 Cross Currency Interest Rate Swaps Fortunately for ABC, it does have a strong relationship with a domestic bank that is experienced in delivering international financing solutions. ABC will raise USD financing. ABC will then enter into a Cross Currency Interest Rate Swap.

22. 22 Cross Currency Interest Rate Swaps The Cross Currency Swap has these primary features: –Converts USD into EURO. Utilize EURO to make investment. –No foreign exchange risk, as EURO investment cash flows are converted to USD for debt service (P&I) based on a pre-determined, fixed exchange rate.

23. 23 Cross Currency Interest Rate Swaps Principal Cashflows Interest Cashflows ABC Euro EURO Investment PNC Capital Markets PNC Bank ABC

24. 24 Cross Currency Interest Rate Swaps Principal Cashflows Interest Cashflows ABC Euro EURO Investment PNC Capital Markets PNC Bank USD Principal ABC

25. 25 Cross Currency Interest Rate Swaps Principal Cashflows Interest Cashflows ABC Euro EURO Investment PNC Capital Markets PNC Bank USD Principal USD Principal Exchange EURO Principal Exchange ABC

26. 26 Cross Currency Interest Rate Swaps Principal Cashflows Interest Cashflows ABC Euro EURO Investment EURO Principal PNC Capital Markets PNC Bank USD Principal USD Principal Exchange EURO Principal Exchange ABC

27. 27 Cross Currency Interest Rate Swaps ABC Euro EURO Investment EURO Principal PNC Capital Markets PNC Bank USD Principal Libor EURO Principal Exchange Libor EURO Swap Rate Principal Cashflows Interest Cashflows ABC EURO Fixed Rate

28. 28 Cross Currency Interest Rate Swaps ABC Euro EURO Investment EURO Principal PNC Capital Markets PNC Bank USD Principal USD Libor USD Principal ExchangeEURO Principal Exchange USD Libor EURO Swap Rate Principal Cashflows Interest Cashflows EURO Fixed Rate ABC

29. 29 Cross Currency Interest Rate Swaps ABC Euro EURO Investment EURO Principal EURO Fixed Rate PNC Capital Markets PNC Bank USD Principal USD Libor USD Principal ExchangeEURO Principal Exchange USD Libor EURO Swap Rate Principal Cashflows Interest Cashflows 12 1 2 3 4 4 5 6 7 8 9 10 11 ABC

30. 30 Cross Currency Interest Rate Swaps Initial principal advances and use of proceeds: 1) PNC Bank lends USD to ABC. 2) ABC delivers USD to PNC Capital Markets. 3) PNC Capital Markets delivers EURO to ABC. 4) ABC lends EURO to ABC Euro. Debt Service Payments: 5) ABC Euro pays EURO interest to ABC. 6) ABC pays EURO Swap Rate to PNC Capital Markets. 7) PNC Capital Markets pays USD Libor to ABC. 8) ABC pays USD Libor to PNC Bank. Payoff Loan & Terminate Swap: 9) ABC retires its EURO Loan from ABC. 10) ABC delivers EURO to PNC Capital Markets. 11) PNC delivers USD to ABC. 12) ABC retires USD loan from PNC Bank.

31. 31 Hedging Financial Market Exposure