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Interest rate swaps
Currency swaps
Fixed
Rate
Available
A: BBB rated 8.5%
Floating
Rate
Available
6-month
LIBOR +
0.5%
6-month
LIBOR
0.5%
6
IRS: Eg.
Co. B with superior credit rating has an
advantage over Co. A in both fixed rate
market & floating rate market
However Bs advantage over A is greater in
the fixed rate market because the credit
spread between BBB & AAA ratings is higher
& more beneficial for B there
As disadvantage wrt B is lesser in the
floating rate market because the credit
spread between BBB & AAA ratings is lower &
more beneficial for A there
7
IRS: Eg.
The advantage which B has over A in both
markets is called absolute advantage it is
the advantage per se without any
comparison with other markets
A comparison between the absolute
advantages / disadvantages across markets
is called Comparative advantage
If firm B has a higher absolute advantage in
market 1 than in market 2 then B is said to
have a comparative advantage in market 1
If firm A has a lower absolute disadvantage
in market 2 than in market 1 then A is said
8
IRS: Eg.
Co. B with superior credit rating has an
absolute advantage over Co. A in both fixed
rate market & floating rate market
B has a comparative advantage in the fixed
rate market because its absolute advantage
is higher & more beneficial for itself there
A has a comparative advantage in the
floating rate market because its absolute
disadvantage is lower & more beneficial for
itself there
9
B
7.5%
LIBOR +
0.5%
Floating
rate
lenders
Net Cost = LIBOR +
0.5% + 7.5% LIBOR =
8.0%
7%
Fixed rate
lenders
Net Cost =
LIBOR + 7% - 7.5%
= LIBOR 0.5%
13
A
LIBO
R
LIBOR +
0.5%
Floating
rate
lenders
Net Cost = LIBOR +
0.5% + 7.35% LIBOR =
7.85%
7.25
%
B
LIBO
R
7%
Fixed rate
lenders
Net Cost =
LIBOR + 7% 7.25% = LIBOR
0.25%
15
Currency Swaps
Designed to manage both interest
rate & exchange rate risks
Involves an exchange of debt
service obligations (DSO)
denominated in different currencies
Cash flows relating to the DSO of
debts denominated in different
currencies are swapped to effect
cash flows in a desired currency
16
Currency Swaps
The two loans that comprise currency swap
have parallel interest & principal repayment
schedules
At each payment date interest in one
currency is exchanged for interest in
another currency
Counterparties also exchange principal
amounts at the start & end of swap
Because the periodic exchange of currencies
is fixed the currency swap is equivalent to a
package of forward contracts in currencies
17
21
USD Rate
Euro Rate
7.5%
7.7%
20 bps
8.25%
8.1%
15 bps
23
USD Rate
MC (Fr.)
7.7%
Difference
20 bps
7.5%
Euro Rate
(Floating)
LIBOR +
0.35%
LIBOR+0.12
5%
22.5 bps
26