Lecture6_SwapI - NBA 6730: Derivative Securities Lecture 6:...

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1 NBA 6730: Derivative Securities Lecture 6: Currency Swaps 09/14/2010 George Gao NBA6730-Derivative Securities I 2 Agenda A swap is a financial contract between two counterparties who exchange future cash flows according to a pre- arranged formula. We study currency swaps in this lecture. Why swap Mechanics of currency swaps Valuation of currency swaps
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2 NBA6730-Derivative Securities I 3 (1) Interest Rate for Swap: LIBOR LIBOR stands for London Interbank Offered Rate The rate at which AA-rated banks borrow/lend funds to each other in the interbank market A popular interest rate for international capital market The rate is determined by interbank transactions and hence it changes frequently LIBOR is widely used in pricing swaps Business and bank borrowing rates move more in tandem with LIBOR than with the government’s borrowing rate (e.g., T-bill rate) LIBOR rates are not risk-free lending rates, but they are close to risk-free NBA6730-Derivative Securities I 4 (2) Why Undertake a Swap? Example: GE and BP have the following borrowing rates (per annum) in $ and £ For simplicity, assume the exchange rate stays at $1.5/£ GE has an absolute advantage in both U.S. and U.K. markets Possible reasons: better credit rating or banking relationship Absolute advantage is not what motivates a swap The comparative advantage is what motivates a swap GE 2% better off in $, 0.4% better off in £, its comparative advantage is to borrow dollars ($) BP 2% worse off in $, 0.4% worse off in £, its comparative advantage is to borrow pounds (£) Dollar $ Pound £ GE 8% 11.6% BP 10% 12%
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3 NBA6730-Derivative Securities I 5 (2) Why Undertake a Swap? The “bad” borrowing combination If BP borrows $15M at 10% rate, the 1 st year interest = $1.5M If GE borrows £10M at 11.6% rate, the 1 st year interest = £ 1.16M (or $1.74M = £1.16 $1.5/ £) BP and GE pay total interest $3.24M in the first year The “good” borrowing combination If GE borrows $15M at 8% rate, the 1 st year interest = $1.2M If BP borrows £10M at 12% rate, the 1 st year interest = £1.2M (or $1.8M = £1.2 $1.5/ £) BP and GE pay total interest $3M in the first year The comparative advantage = $3.24 - $3 = $0.24M in interest payment (or interest rate 1.6% = $0.24M/$15M) NBA6730-Derivative Securities I 6 (2) Why Undertake a Swap?
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Lecture6_SwapI - NBA 6730: Derivative Securities Lecture 6:...

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