Chapter 12 Using Swaps to Manage Risk Swaps

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Chapter 12 Using Swaps to Manage Risk • Swaps can be used to lower

Chapter 12 Using Swaps to Manage Risk • Swaps can be used to lower borrowing costs and generate higher investment returns. • Swaps can be used to transform floating rate assets into fixed rate assets, and vice versa. • Swaps can transform floating rate liabilities into fixed rate liabilities, and vice versa. • Swaps can transform the currency behind any asset or liability into a different currency. ©David Dubofsky and 12 -1 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, I. • Two firms can enter into a plain

Swapping to Lower Borrowing Costs, I. • Two firms can enter into a plain vanilla swap to exploit their comparative advantages regarding quality spread differentials. • For example: – Firm B is a low-rated, risky, firm. It can borrow at a fixed rate of 8%, or at a floating rate of LIBOR + 75 bp. – Potential counter-party, Firm A, can borrow at a fixed rate of 7%, or at a floating rate of LIBOR +25 bp. ©David Dubofsky and 12 -2 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, II. • Suppose Firm B wishes to borrow at

Swapping to Lower Borrowing Costs, II. • Suppose Firm B wishes to borrow at a fixed rate, and Firm A wishes to borrow at a variable rate. • Although B faces higher rates in both markets, it has a comparative advantage in the floating rate market. – It is paying only 50 bp more in the floating rate market, but it must pay 100 bp more in the fixed rate market. • Firm A has a comparative advantage in the fixed rate market because – Firm A is paying 100 bp less there, compared to 50 bp less in the floating rate market. ©David Dubofsky and 12 -3 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, III. Fixed at 7. 1% Firm B Firm A

Swapping to Lower Borrowing Costs, III. Fixed at 7. 1% Firm B Firm A THE SWAP Floating at LIBOR pays floating LIBOR + 75 bp borrows NP at a variable rate pays fixed rate of 7% borrows NP at a fixed rate Capital Market Net result: Firm B has borrowed at a fixed rate of 7. 85%, and Firm A has borrowed at a floating rate equal to LIBOR - 10 bp. Both counter-parties to this swap have lowered their interest expense by swapping. ©David Dubofsky and 12 -4 Thomas W. Miller, Jr.

Swapping to Lower Borrowing Costs, IV. • The gains to these types of swaps

Swapping to Lower Borrowing Costs, IV. • The gains to these types of swaps (that lower borrowing costs) have diminished in recent years, but judging from surveys on derivatives usage, the gains still exist. • These swaps are done with swap dealers (intermediaries); firms don’t do them between themselves. Firm B 7. 12% fixed Floating LIBOR Swap Dealer 7. 08% fixed Floating LIBOR Fir m A ©David Dubofsky and 12 -5 Thomas W. Miller, Jr.

Using a Swap to Transform Liabilities: Party A is hedging against rising interest rates;

Using a Swap to Transform Liabilities: Party A is hedging against rising interest rates; Party B will then benefit from falling interest rates ‘A’ has an existing floating rate loan LIBOR A 5% The Swap LIBOR B 6% ‘B’ has an existing fixed rate loan The result (with the swap) is that A will be paying 5% fixed. B will be paying LIBOR + 100 bp. ©David Dubofsky and 12 -6 Thomas W. Miller, Jr.

Using a Swap to Transform Assets: Party A is locking in a fixed rate

Using a Swap to Transform Assets: Party A is locking in a fixed rate of return; Party B will benefit from rising interest rates ‘A’ owns an existing floating rate bond 5% LIBOR A The Swap LIBOR B 6% ‘B’ owns an existing fixed coupon bond The result (with the swap) is that A will be receiving 5% fixed. B will be receiving LIBOR + 100 bp. ©David Dubofsky and 12 -7 Thomas W. Miller, Jr.

Using a Currency Swap to Hedge Against an increase in the Price of a

Using a Currency Swap to Hedge Against an increase in the Price of a Foreign Currency • Transform a liability in one currency into a liability in another currency. • Transform an expense (cost) in one currency into a another currency. Before the swap, this U. S. firm loses if the $/ ¥ exchange rate rises. ¥ ¥ $ ©David Dubofsky and 12 -8 Thomas W. Miller, Jr.

Using a Currency Swap to Hedge Against a Decrease in the Price of a

Using a Currency Swap to Hedge Against a Decrease in the Price of a Foreign Currency • Transform an investment in one currency into an asset in another currency. • Transform a revenue in one currency into a another currency. € $ € Before the swap, this U. S. firm loses if the $/€ exchange rate falls. ©David Dubofsky and 12 -9 Thomas W. Miller, Jr.

Comparative Advantage for Currency Swaps • Two firms can enter into a currency swap

Comparative Advantage for Currency Swaps • Two firms can enter into a currency swap to exploit their comparative advantages regarding borrowing in different countries. • That is, suppose: – Firm B can borrow in $ at 8. 0%, or in € at 6. 0%. – Firm A can borrow in $ at 6. 5% or in € at 5. 2%. • If A wants to borrow €, and B wants to borrow $, then they may be able to save on their borrowing costs if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities. ©David Dubofsky and 12 -10 Thomas W. Miller, Jr.

Using Commodity Swaps: Examples • An airline wants to lock in the price it

Using Commodity Swaps: Examples • An airline wants to lock in the price it pays for ‘x’ gallons of jet fuel per quarter. – In each of the next N years, the airline will agree to pay a fixed price and receive the floating price. • A gold producer wants to lock in the price it receives for ‘z’ oz. of gold each month. – In each of the next M years, the gold producer will agree to pay a floating price and receive a fixed price. ©David Dubofsky and 12 -11 Thomas W. Miller, Jr.

Using Equity Swaps: Examples • A bearish portfolio manager might agree to pay, each

Using Equity Swaps: Examples • A bearish portfolio manager might agree to pay, each month, the monthly rate of return on a portfolio of stocks, and receive a floating rate of return linked to LIBOR (divided by 12), receive a fixed payment. • Note if the portfolio of stocks declines in value, the portfolio manager actually receives two cash flows! ©David Dubofsky and 12 -12 Thomas W. Miller, Jr.