Foundations of Multinational Financial Management 5 th Edition

Foundations of Multinational Financial Management 5 th Edition Alan Shapiro J. Wiley & Sons Power Points by Joseph F. Greco, Ph. D. California State University, Fullerton 1

SWAPS AND INTEREST RATE DERIVATIVES CHAPTER 9 2

CHAPTER OVERVIEW I. III. Interest Rate and Currency Swaps Interest Rate Forwards and Futures Structured Notes 3

I. INTEREST RATE AND CURRENCY SWAPS A. INTEREST RATE SWAPS 1. Definition an agreement between 2 parties to exchange US$ interest payments for a specific maturity on an agreed notional amount. 4

THE CLASSIC SWAP a. b. Notional principal: a reference amount used only to calculate interest expense but never repaid. Maturities: less than 1 to over 15 years. 5

THE CLASSIC SWAP 2. Types a. Coupon swap b. Basis swap 3. LIBOR: The most important reference rate in a swap 4. Swap Usage: To reduce risk potential and costs. 6

THE CURRENCY SWAP B. Currency Swaps 1. Definition Two parties exchange foreign currencydenominated debt at periodic intervals. 2. Purpose: similar to parallel loan 7

THE CURRENCY SWAP 3. Differences of a Currency Swap: a. Currency swap is not a loan b. No interest expense; no balance sheet entry c. The right to offset any non-payment is more firmly established 8

THE CURRENCY SWAP 4. Similarities between Interest Rate and Currency Swaps a. Avoid exchange rate risk b. Exchange rate is only a reference to determine amounts exchanged 5. Economic Benefits of Swaps when arbitrage prohibited, they provide long-term financing. 9

II. INTEREST RATE FORWARDS AND FUTURES Forward and futures contracts: - three types used to manage interest rate risk A. Forward forwards B. Forward rate agreements C. Eurodollar futures 10

INTEREST RATE FORWARDS AND FUTURES Forward forwards 1. A contract that fixes an interest rate today on a future loan or deposit. 2. Contract conditions: - specific interest rate - principal amount of future loan - start and ending dates of future interest rate period. 11

INTEREST RATE FORWARDS AND FUTURES Forward rate agreements (FRAs) 1. Cash-settled 2. Over-the-counter forward contract 3. Company fixes an interest rate applied to a specified future interest period on a notional amount. 12

INTEREST RATE FORWARDS AND FUTURES Eurodollar Futures 1. A cash-settled futures contract for a 3 month Eurodollar deposit paying LIBOR 2. Contracts traded on: a. Chicago Mercantile Exchange b. London International Financial Futures Exchange c. Singapore International Monetary Exchange 13

III. STRUCTURED NOTES Interest-bearing securities whose interest payments are determined by reference to a formula set in advance and adjusted on specific reset dates. 14

STRUCTURED NOTES Inverse Floaters: A floating-rate instrument whose interest rate moves inversely with market interest rates. 15