hedging financial market exposure interest rate swaps cross currency interest rate swaps

Hedging Financial Market Exposure

Interest Rate SwapsCross Currency Interest Rate Swaps

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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.

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Interest Rate Swaps

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Interest Rate Swaps

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.

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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.

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Interest Rate Swaps

Historical Prime and Libor rates

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

3/1/90

3/1/92

3/1/94

3/1/96

3/1/98

3/1/00

3/1/02

Prime

LIBOR

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Interest Rate Swaps

Historical yield on 5 Year Treasury Note

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

3/1/90 3/1/92 3/1/94 3/1/96 3/1/98 3/1/00 3/1/02

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Interest Rate Swaps

Forward Interest Rate Curve on LIBOR

3.00%

4.00%

5.00%

6.00%

7.00%

9/1/01 9/1/02 9/1/03 9/1/04 9/1/05 9/1/06

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Interest Rate Swaps

ABC

PNC Bank

Libor + 2.00%

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Interest Rate Swaps

PNC Capital Markets

ABC

PNC Bank

Libor + 2.00%

Libor

Swap Rate: 5.50%

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Interest Rate Swaps

Swap Details:

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

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Interest Rate Swaps

Interest Rate Swap Mechanics

Floating Rate LoanABC Pays LIBOR 3.75% 5.75% 1.75%ABC Pays Spread 2.00% 2.00% 2.00%Loan Interest 5.75% $14,375 7.75% $19,375 3.75% $9,375

Interest Rate SwapABC Receives LIBOR -3.75% -5.75% -1.75%ABC Pays Swap Rate 5.50% 5.50% 5.50%Swap Payment (Receipt) 1.75% $4,375 -0.25% ($625) 3.75% $9,375

All-In Rate 7.50% $18,750 7.50% $18,750 7.50% $18,750

Current What if Rates Rise What if Rates Fall

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ABC

Bondholder

Fixed Coupon:7.25%

Interest Rate Swaps

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PNC Capital Markets

ABC

Bondholder

Fixed Coupon:7.25%

Libor + 1.75%

Swap Rate: 7.25%

Interest Rate Swaps

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• 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

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Cross Currency Interest Rate Swaps

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• 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.

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Cross Currency Interest Rate SwapsABC EuroEURO Investment

Principal CashflowsInterest Cashflows

Bank of Euro

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• Unfortunately for ABC, it is unable to raise EURO denominated financing from a European bank.

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Loan

Request

ABC EuroEURO Investment

Bank of Euro

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• 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.

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• 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.

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PNC Capital Markets

PNC Bank

ABC

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PNC Capital Markets

PNC Bank

USD Principal

ABC

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PNC Capital Markets

PNC Bank

USD Principal

USD Principal Exchange

EURO Principal Exchange

ABC

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EURO Principal

PNC Capital Markets

PNC Bank

USD Principal



ABC

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EURO Principal

PNC Capital Markets

PNC Bank

USD Principal

Libor


Libor

EURO Swap Rate


ABC

EURO Fixed Rate

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EURO Principal

PNC Capital Markets

PNC Bank

USD Principal

USD Libor



USD Libor

EURO Swap Rate


EURO Fixed Rate

ABC

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EURO Principal

EURO Fixed Rate

PNC Capital Markets

PNC Bank

USD Principal

USD Libor



USD Libor

EURO Swap Rate


12

12

3

44

5

67

8

9

10

11

ABC

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Cross Currency Interest Rate SwapsInitial 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.

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Hedging Financial Market Exposure

The data contained herein is based upon information obtained from sources believed to be reliable, but since it has not been independently verified, such data is not guaranteed as to accuracy or completeness. All pricing is indicative and subject to firm quotes. The above is intended for informational purposes only and should not be construed as trading advice or recommendations to buy or sell currencies or securities or to engage in any other transaction. Swap, collar and FRA transactions are subject to PNC Bank credit approval.

Clients should evaluate the financial, market, legal, regulatory, credit, tax and accounting risks and consequences of the any and all transactions proposed before entering into or purchasing any instrument, involving a financial derivative. Clients should undertake their own evaluation of the risks and consequences of a transaction independently of PNC Bank. PNC Bank assumes no liability for any errors or omissions in this presentation.

hedging financial market exposure interest rate swaps cross currency interest rate swaps

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