MGTC71-6 - MGTC71-Lecture 6 SWAPS Ata Mazaheri 1 Outline...

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1 MGTC71-Lecture 6 SWAPS Ata Mazaheri
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2 Outline Swaps Valuing Plain Vanilla Interest Swaps Valuing Swaps after Origination
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3 Nature of Swaps A swap is an agreement to exchange cash flows at specified future times according to certain specified rules
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4 An Example of a “Plain Vanilla” Interest Rate Swap An agreement by Microsoft to receive 6- month LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a notional principal of $100 million Next slide illustrates cash flows
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5 ---------Millions of Dollars--------- LIBOR FLOATING FIXED Net Date Rate Cash Flow Cash Flow Cash Flow Mar.5, 2004 4.2% Sept. 5, 2004 4.8% +2.10 –2.50 –0.40 Mar.5, 2005 5.3% +2.40 –2.50 –0.10 Sept. 5, 2005 5.5% +2.65 –2.50 +0.15 Mar.5, 2006 5.6% +2.75 –2.50 +0.25 Sept. 5, 2006 5.9% +2.80 –2.50 +0.30 Mar.5, 2007 6.4% +2.95 –2.50 +0.45 Cash Flows to Microsoft
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6 Typical Uses of an Interest Rate Swap Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate
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7 Intel and Microsoft (MS) Transform a Liability Intel MS LIBOR 5% LIBOR+0.1% 5.2%
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8 Financial Institution is Involved F.I. LIBOR LIBOR LIBOR+0.1% 4.985% 5.015% 5.2% Intel MS
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9 Intel and Microsoft (MS) Transform an Asset Intel MS LIBOR 5% LIBOR-0.2% 4.7%
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10 Financial Institution is Involved Intel F.I. MS LIBOR LIBOR 4.7 % 5.015% 4.985% LIBOR-0.2%
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11 Quotes By a Swap Market Maker Maturity Bid (%) Offer (%) Swap Rate (%) 2 years 6.03 6.06 6.045 3 years 6.21 6.24 6.225 4 years 6.35 6.39 6.370 5 years 6.47 6.51 6.490 7 years 6.65 6.68 6.665 10 years 6.83 6.87 6.850
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12 The Comparative Advantage Argument AAACorp wants to borrow floating BBBCorp wants to borrow fixed Fixed Floating AAACorp 4.0% 6-month LIBOR + 0.30% BBBCorp 5.20% 6-month LIBOR + 1.00%
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13 The Swap AAACorp BBBCorp LIBOR LIBOR+1% 3.95% 4% AAA:{Libor+.3}-{Fixed(AAA)-Swap+Libor}=0.3-Fixed(AAA)+Swap BBB:{Fixed(BBB)}-{[Libor+1%]+Swap-Libor}=Fixed (BBB)- Swap-1% Total Gain:1+2=[Fixed(AAA)-Fixed(BBB)]-[1%-0.3%]=0.5% The difference between the fixed - the difference between the Libors.
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MGTC71-6 - MGTC71-Lecture 6 SWAPS Ata Mazaheri 1 Outline...

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