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10
FINANCIAL
MANAGEMENT
Chapter Objective:
Chapter Outline
Types of Swaps
Size of the Swap Market
The Swap Bank
Interest Rate Swaps
Currency Swaps
Definitions
In a swap, two counterparties agree to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
There are two types of interest rate swaps:
U.S.$ (34%)
(23%)
DM (11%)
FF (10%)
(6%)
Fixed rate
Floating rate
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
Bank
LIBOR 1/8%
Bank
A
Fixed rate
Floating rate
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
Swap
Bank
LIBOR 1/8%
10%
Bank
LIBOR % which is %
better than they can borrow
floating without a swap.
Fixed rate
Floating rate
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
Fixed rate
Floating rate
Swap
Bank
10 %
LIBOR %
Company
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
Bank
% of $10,000,000 =
$50,000 thats quite a cost
savings per year for 5
10 %
years.
Company
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
LIBOR
+ %
Bank
LIBOR %
LIBOR 1/8%
10%
% of $10 million
= $25,000 per year
for 5 years.
10 %
Swap
Bank
A
A saves %
Fixed rate
Floating rate
Company
10 - 10 3/8 = 1/8
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
LIBOR
+ %
B
B saves %
Swap
Bank
LIBOR %
LIBOR 1/8%
10%
10 %
Company
Bank
A
A saves %
Fixed rate
Floating rate
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
LIBOR
+ %
B
B saves %
The QSD
The Quality Spread Differential represents the
potential gains from the swap that can be shared
between the counterparties and the swap bank.
There is no reason to presume that the gains will
be shared equally.
In the above example, company B is less creditworthy than bank A, so they probably would have
gotten less of the QSD, in order to compensate the
swap bank for the default risk.
Company A
8.0%
11.6%
Company B
10.0% 12.0%
Company
A
Bank
$9.4%
12%
11%
Company
B
$
Company A
8.0%
11.6%
Company B
10.0% 12.0%
12%
Bank
$9.4%
12%
11%
Company
Company
A
As net position is to borrow at 11%
$8%
Company A
8.0%
11.6%
Company B
10.0% 12.0%
A saves .6%
12%
$8%
$8%
Company
A
$9.4%
12%
11%
Company
12%
B
Bs net position is to borrow at $9.4%
$
Company A
8.0%
11.6%
Company B
10.0% 12.0%
B saves $.6%
Swap
Bank
12%
11%
Company 12%
Company
At S0($/) = $1.60/,
A
that is a gain of
B
$124,000 per year for 5
The swap bank
years.
$
Comparative Advantage
as the Basis for Swaps
A is the more credit-worthy of the two firms.
A pays 2% less to borrow in dollars than B
A pays .4% less to borrow in pounds than B:
$
Company A
8.0%
11.6%
Company B
10.0% 12.0%
Comparative Advantage
as the Basis for Swaps
B has a comparative advantage in borrowing in .
B pays 2% more to borrow in dollars than A
$
Company A
8.0%
11.6%
Company B
10.0% 12.0%
Comparative Advantage
as the Basis for Swaps
A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.
If they borrow according to their comparative advantage and then swap, there will be gains for both parties.
Currency Swaps
Basis Risk
Credit Risk
Mismatch Risk
Sovereign Risk
Pricing a Swap
A swap is a derivative security so it can be priced
in terms of the underlying assets:
How to:
Concluding Remarks
The growth of the swap market has been
astounding.
Swaps are off-the-books transactions.
Swaps have become an important source of
revenue and risk for banks