ix: market innovations 27: swap agreements credit arbitrage swap currency swap
DESCRIPTION
Chapter 27: Swap Agreements © Oltheten & Waspi 2012 Credit Arbitrage Swap SWAP debt payments to get from the market in which you can borrow at the lowest rate to the market in which you want to pay interest. Need to borrow $10m Rating 10 Year Bond Rate 6 month Commercial Paper Rate Bank of AmericaAAA10.00%T-Bill % Hypothetical ResourcesBBB11.90%T-Bill %TRANSCRIPT
IX: Market Innovations
27: Swap AgreementsCredit Arbitrage SwapCurrency Swap
Chapter 27: Swap Agreements
Credit Arbitrage Swap
© Oltheten & Waspi 2012
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Credit Arbitrage Swap
SWAP debt payments to get from the market in which you can borrow at the lowest rate to the market in which you want to pay interest.
Need to borrow $10mRating
10 YearBond Rate
6 month Commercial Paper Rate
Bank of America AAA 10.00% T-Bill + 0.30%Hypothetical Resources BBB 11.90% T-Bill + 0.80%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Credit Arbitrage Swap
Need to borrow $10mRating
10 YearBond Rate
6 month Commercial Paper Rate
Bank of America AAA 10.00% T-Bill + 0.30%Hypothetical Resources BBB 11.90% T-Bill + 0.80%
190 bp 50 bp
Market in which we would rather pay interest
Market in which we would rather pay interest
Market in which BofA has an absolute advantage
Market in which we have a comparative advantage
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Credit Arbitrage Swap
Need to borrow $10mRating
10 YearBond Rate
6 month Commercial Paper Rate
Bank of America AAA 10.00% T-Bill + 0.30%Hypothetical Resources BBB 11.90% T-Bill + 0.80%
190 bp 50 bp
… and swap into a fixed interest payment
… and swap into a variable interest payment
BofA will borrow in the 10yr fixed market …
HR will borrow in the 6 month fixed market …
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Borrow
Each company borrows in the market in which it has a comparative advantage.
Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds
-10.00% Borrow $10 million in Commercial Paper
- (TB + 0.80)%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Swap a fixed payment
Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds
-10.00 % Borrow $10 million in Commercial Paper
- (TB + 0.80)%
Swap: fixed payment +11.00 % Swap: fixed payment -11.00 %
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Swap a variable payment
Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds
-10.00 % Borrow $10 million in Commercial Paper
- (TB + 0.80)%
Swap: fixed payment
+11.00 % Swap: fixed payment
-11.00 %
Swap: variable payment
- (TB +0.70)% Swap: variable payment
+(TB + 0.50)%
0.20% to intermediary
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Net debt payment
Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds
- 10.00 % Borrow $10 million in Commercial Paper
- (TB + 0.80)%
Swap: fixed payment
+ 11.00 % Swap: fixed payment
- 11.00 %
Swap: variable payment
- (TB + 0.70)% Swap: variable payment
+(TB + 0.50)%
NET: - (TB - 0.30)% NET: - 11.30 %
-10.00 + 11.00 – TB - 0.70=- TB + 0.30
= - (TB - 0.30)- TB - 0.80 - 11.00 + TB + 0.50
=- 11.30
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Credit Arbitrage Swap
Need to borrow $10mRating
10 YearBond Rate
6 month Commercial Paper Rate
Bank of America AAA 10.00% T-Bill + 0.30%Hypothetical Resources BBB 11.90% T-Bill + 0.80%
190 bp 50 bp
Net Payment is 11.30%
Net payment is T-Bill – 0.30%
Gain of 0.60%
Gain of 0.60%
Intermediary gets 0.20%
Total Gains from Swap: 140 basis points
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Credit Arbitrage SwapNeed to borrow $10m
Rating10 Year
Bond Rate6 month
Commercial Paper RateBank of America AAA 10.00% T-Bill + 0.30%
Hypothetical Resources BBB 11.90% T-Bill + 0.80%Difference: 190 50
Total Gain = 1.40% = 140 basis points
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Engineering the Swap Calculate the advantage
140 basis points Distribute the advantage
60 basis points to Bank of America 60 basis points to Hypothetical Resources 20 basis points to the Intermediary
Calculate the swap backwards from the bottom line
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Engineering the Swap
Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds
- 10.00 % Borrow $10 million in Commercial Paper
- (TB + 0.80)%
NET: - (TB - 0.30)% NET: - 11.30 %
-(TB + 0.30) + 0.60 = - (TB - 0.30) -11.90 + 0.60 = - 11.30
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Engineering the Swap
Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds
- 10.00 % Borrow $10 million in Commercial Paper
- (TB + 0.80)%
Swap: fixed payment
+ 11.00 % Swap: fixed payment
- 11.00 %
NET: - (TB - 0.30)% NET: - 11.30 %
Set the fixed payment
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Engineering the Swap
Bank of America Hypothetical ResourcesBorrow $10m in 10 year bonds
- 10.00 % Borrow $10 million in Commercial Paper
- (TB + 0.80)%
Swap: fixed payment
+ 11.00 % Swap: fixed payment
- 11.00 %
Swap: variable payment
- (TB + 0.70)% Swap: variable payment
+(TB + 0.50)%
NET: - (TB - 0.30)% NET: - 11.30 %
Calculate the variable payment
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Swap: Payment Flow
Bank ofAmerica
T-Bill – 0.30
Long Term Debt M
arketCo
mm
ercia
l Pap
er M
arke
t
HypotheticalResources
11.30%
Intermediary
10.00%
T-Bill + 0.80 %
.20%
T-Bill + 0.50 %
11.00%
$10,000,000 Notional Principal Amount
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Swap Payments Suppose the T-Bill rate is
9.0% at the end of 12 months 10.5% at the end of 6 months 12.0% at the end of 18 months
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
T-Bill Rate: 9.0%
$75,000
Bank ofAmerica
T-Bill – 0.308.7%
Long Term Debt M
arketCo
mm
ercia
l Pap
er M
arke
t
HypotheticalResources
11.30%
Intermediary
10.00%
T-Bill +0.809.80%
.20%
11.00%
$10,000,000 Notional Principal Amount
T-Bill +0.509.50 %
1.50%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
T-Bill Rate: 10.5%
$0
Bank ofAmerica
T-Bill – 0.30
10.2%
Long Term Debt M
arketCo
mm
ercia
l Pap
er M
arke
t
HypotheticalResources
11.30%
Intermediary
10.00%
T-Bill +0.8011.30%
.20%
11.00%
$10,000,000 Notional Principal Amount
T-Bill +0.5011.00 %
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
T-Bill Rate: 12.0%
$75,000
Bank ofAmerica
T-Bill – 0.30
11.7%
Long Term Debt M
arketCo
mm
ercia
l Pap
er M
arke
t
HypotheticalResources
11.30%
Intermediary
10.00%
T-Bill +0.8012.80%
.20%
11.00%
$10,000,000 Notional Principal Amount
T-Bill +0.5012.50 %
1.50%
Chapter 27: Swap Agreements
Currency Swap
© Oltheten & Waspi 2012
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Currency Swap
RatingRate in the
USAEuro Rate
BoeingNeeds to borrow €10m
AAA 5.00% 12.60%
AirleaseNeeds to borrow $9m
BBB 7.00% 13.00%
Difference 200 bp 40 bp
Each company has a comparative advantage in the “wrong” currency so we use a swap to put each company in the target currency at a lower rate.
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Borrow
Each company borrows in the market in which it has a comparative advantage.
Boeing Airlease
Borrow $9m -5.00% Borrow €10m -13.00%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Swap Principal
Boeing (€10m) Airlease ($9m)
Borrow $9m -5.00% Borrow €10m -13.00%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Neutralize Currency Risk
Boeing (€10m) Airlease ($9m)
Borrow $9m -5.00% Borrow €10m -13.00%
Swap: Dollars + $9m * 5.00% Swap: Euros + €10m * 13.00%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Calculate the advantage
Total Advantage: 160 basis pointsBoeing (€10m) Airlease ($9m)
Borrow $9m -5.00% Borrow €10m -13.00%
Take 20 basis points for the Intermediary and distribute the remaining 140 basis points equallyOriginal Euro Rate - 12.60% Original Dollar Rate - 7.00%
Swap advantage + .70% Swap advantage + .70%
Net: - 11.90% Net: - 6.30%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Distribute the advantage
Boeing (€10m) Airlease ($9m)
Borrow $9m -5.00% Borrow €10m -13.00%
Swap: Dollars + $9m * 5.00% Swap: Euros + €10m * 13.00%
Net: - €10m * 11.90% Net: - $9m * 6.30%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Calculate the Swap
Boeing (€10m) Airlease ($9m)
Borrow $9m -5.00% Borrow €10m -13.00%
Swap: Dollars + $9m * 5.00% Swap: Euros + €10m * 13.00%
Swap: Euros - €10m * 11.90% Swap: Dollars - $9m * 6.30%
Net: - €10m * 11.90% Net: - $9m * 6.30%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Currency Swap We have completely eliminated the foreign
exchange risk for both counterparties by transferring exchange risk completely to the Intermediary
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Payment Flow
With no swap
Airlease Euro Debt Market
US D
olla
r Deb
t Mar
ket Boeing Intermediar
y
€10m @13.00%
$9m * 5.00 %$9m * 6.30 %
€10m * 13.00%€10m * 11.90%
$9m * 5.00 %$9m * 7.00 %
€10m @12.60%
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Payment Flow
AirleaseBoeing Intermediary
+ 1.3% of $9m
- 1.1% of €10m
Net: 0.20%+ All the exchange risk
$9m * 6.30 %
€10m * 13.00%€10m * 11.90%
$9m * 5.00 %
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Intermediary’s Foreign Exchange Risk Every six months the Intermediary
Takes in ½(1.3% of $9m) = $58,500. Pays out ½(1.1% of €10m) = €55,000. Profit:
Π = $58,500 - €55,000 * $ exchange€ .
Chapter 27: Swap Agreements © Oltheten & Waspi 2012
Intermediary’s ForEx Risk
-$30,000
-$25,000
-$20,000
-$15,000
-$10,000
-$5,000
$0
$5,000
$10,000
$15,000
$0.80 $0.90 $1.00 $1.10 $1.20 $1.30 $1.40 $1.50 $1.60
$1.0636
$1.40
-$24,000
Swap Agreements