1. Interest Rate SWAPs Mefielding.com mefielding.com 1

2. Interest Rate SWAPS A swap is the situation where 2 companies borrow money. They (sort of) pay each others interest and by doing this they save money Steel Co is a large company, asset backed. It wants to borrow $25m fixed rate because it believes interest rates will rise. An investment bank tells it, it can borrow floating rate (bank) at LIBOR +20 or fixed rate (bond market) at 5%. Acconting Co is a consulting group. It has a long history of profits and has a good credit rating. Acconting believes interest rates will fall and wants to borrow $25m floating rate. The investment bank tells Acconting it can borrow at LIBOR +90 or fixed 5.20% The investment bank offers to organize an interest rate swap for a fee of 10 basis points jointly payable from interest payments Both loans have a life of 5 years mefielding.com 2 3. Interest Rate SWAPS Step 1 Calculate the differential, this is the profit to be shared mefielding.com 3 Floating Fixed % Steel LIBOR +20 5 Acconting LIBOR+ 90 5.20 Steels advantage 70 20 4. Interest Rate SWAPS- Step 2 The differential is 50 basis points (0.5%) This will be split 10 basis points to the bank and 20 basis points to each company. First draw the outline mefielding.com 4 Acc Bank Steel 5. Interest Rate SWAPS Steel is the largest company, therefore we start with Steel. Steel will issue into the market in which it has the largest advantage. From slide 3 this is the floating rate Steel will therefore borrow $25m from a bank and Acconting will issue bonds with a value of $25m mefielding.com 5 6. Interest Rate SWAPS Steps 3 &4 mefielding.com 6 Acc Bank Steel LIBOR+20 5.20% LIBOR+90 LIBOR+90 7. Interest Rate SWAPS Current situation for Steel is that it is receiving 70 basis points (0.7%) We said originally (slide 3) they had to pay 5% but would receive 20 basis points of benefit. The net cost therefore must be 4.8% If Steel is currently receiving 0.7% then Steel must pay fixed 5.5%- gives net 4.8% The bank will take 10 basis points as its fee so Acconting receives 5.4% mefielding.com 7 8. Interest Rate SWAPS mefielding.com 8 Acc Bank Steel 5.20% LIBOR+20 LIBOR+90 LIBOR+90 5.5%5.4% 9. Interest Rate SWAPS Steel pays LIBOR +20 and 5.5% but receives LIBOR+90. Net 4.8% fixed which is 20 basis points less than they would have expected Acconting pays 5.2% and LIBOR+90 but receives 5.4%. The net is LIBOR plus 70 which is 20 basis points less than if they had borrowed floating mefielding.com 9 10. Risks of Interest Rate SWAPS Floating rate risk Basis risk Default risk mefielding.com 10