swap

Example on an interest rate swap

We have two companies A and B. A has an opportunity to raise funds at a lower price. Both companies can select between a fixed interest and a floating interest loan.The current offer rates for the two companies are:

Company A Company BFixed Interest Rate 6.00% 9.00%Floating Interest Rate Euribor + 1.00% Euribor + 2.00%

The current 6 month Euribor rate is 6.00%

A selects the fixed interest rate, B selects the floating rate.The two companies have, however, different expectations on the future development of the 12 months Euribor:

A and B can make a profit by the following interest rate SWAP agreement:

Fixed rate6.00%

Euribor

Fixed rate 6.00% Euribor + 2.00%

Comparing the net interest flows shows us that both companies can win in the arrangement

Finance Market SWAPEuribor + 1.00% Euribor

9.00% 8.00%Floating interest for Company AFixed interest for Company B

3.00%4.00%5.00%6.00%7.00%8.00%9.00%

10.00%

Interest Rates faced by Company A

Fixed Interest Rate

True Euribor + 1.00%

Exp. Euribor + 1.00%

3.00%4.00%5.00%6.00%7.00%8.00%9.00%

10.00%11.00%

Interest Rates faced by Company B

Fixed Interest Rate

True Euribor + 2.00%

Floating Interest Rate

Company A Company B

Outside Lender (Bank)

Outside Lender (Bank)

Date Market Company A Company B

True 6 m

Tru

e E

urib

or

Tru

e E

urib

or +

1.0

0%

Exp

. Eur

ibor

+ 1

.00%

1.1.X1 6.00% 6.00% 6.00% 7.00% 7.00% 9.00%1.7.X1 6.50% 6.00% 5.00% 7.50% 6.00% 9.00%1.1.X2 5.80% 6.00% 4.50% 6.80% 5.50% 9.00%

The two companies have, however, different expectations on the future development of the 12 months Euribor: 1.7.X2 4.70% 6.00% 5.00% 5.70% 6.00% 9.00%1.1.X3 5.80% 6.00% 4.00% 6.80% 5.00% 9.00%1.7.X3 7.80% 6.00% 3.80% 8.80% 4.80% 9.00%1.1.X4 7.20% 6.00% 4.00% 8.20% 5.00% 9.00%1.7.X4 5.40% 6.00% 3.90% 6.40% 4.90% 9.00%1.1.X5 4.80% 6.00% 4.10% 5.80% 5.10% 9.00%1.7.X5 4.50% 6.00% 3.80% 5.50% 4.80% 9.00%1.1.X6 5.00% 6.00% 3.90% 6.00% 4.90% 9.00%1.7.X6 6.20% 6.00% 4.00% 7.20% 5.00% 9.00%1.1.X7 6.60% 6.00% 4.20% 7.60% 5.20% 9.00%1.7.X7 6.90% 6.00% 4.00% 7.90% 5.00% 9.00%1.1.X8 5.70% 6.00% 4.10% 6.70% 5.10% 9.00%1.7.X8 5.30% 6.00% 3.80% 6.30% 4.80% 9.00%1.1.X9 5.50% 6.00% 4.00% 6.50% 5.00% 9.00%1.7.X9 5.90% 6.00% 4.20% 6.90% 5.20% 9.00%

Euribor + 2.00%

Fixed Interest

Rate

Expected 6 month Helibor

Floating Interest Rate

Fixed Interest

Rate

3.00%4.00%5.00%6.00%7.00%8.00%9.00%

10.00%11.00%

Interest Rates faced by Company B

Fixed Interest Rate

True Euribor + 2.00%

Floating Interest Rate

Company B

Outside Lender (Bank)

Company B

Tru

e E

urib

or +

2.0

0%

Exp

. Eur

ibor

+ 2

.00%

6.00% 8.00% 8.00%7.00% 8.50% 9.00%7.50% 7.80% 9.50%6.80% 6.70% 8.80%7.20% 7.80% 9.20%7.60% 9.80% 9.60%8.00% 9.20% 10.00%7.80% 7.40% 9.80%8.40% 6.80% 10.40%8.00% 6.50% 10.00%8.20% 7.00% 10.20%7.60% 8.20% 9.60%8.00% 8.60% 10.00%7.80% 8.90% 9.80%8.20% 7.70% 10.20%7.80% 7.30% 9.80%7.70% 7.50% 9.70%7.80% 7.90% 9.80%

Expected 6 month Helibor

Floating Interest Rate

CASE 1:TESTING THE EXAMPLEA and B have each taken the following bullet loan:

Bullet loan 100000Lump sum repayment period (years) 5Interest payment period (months) 6

Calculate the interest payment streams for A and B in the following cases (use the interest rates of example 1)

a) According to the preferred financing arrangement allowed by the marketb) A and B engage in the SWAP-agreement and their own expectations hold truec) A and B engage in the SWAP-agreement under the true market conditionsd) Determine the break even level for the fixed rate.

Is the SWAP arrangement a good and central instrument for hedging in corporate finance? What are the pitfalls and can they be avoided?

Financing costs before SWAP-agreementCompany A Company B

Fixed Interest Rate 6.00% 9.00%Floating Interest Rate Helibor + 1.00% Helibor + 2.00%

Financing costs after SWAP-agreementFinance Market SWAPHelibor + 1.00% Euribor

9.00% 8.00%

e) Include a theoretical analysis of SWAPS based on Hull and a fresh international journal article.

Floating interest for Company A

Fixed interest for Company B

Calculate the interest payment streams for A and B in the following cases (use the interest rates of example 1)

Is the SWAP arrangement a good and central instrument for hedging in corporate finance?Include a theoretical analysis of SWAPS based on Hull and a fresh international journal article.

HOW TO PRESENT THE SWAP-CASE !

COMPANY A COMPANY AWITHOUT SWAP-AGREEMENT EURIBOR + 1 % WITH SWAP-AGREEMENT EURIBOR

% FIM % FIM % FIM % FIM

FIXED INTEREST RATE

(6 %)

TRUE INTEREST RATE

EXPECTED INTEREST RATE

TRUE INTEREST RATE

EXPECTED INTEREST RATE

COMPANY B COMPANY BWITHOUT SWAP-AGREEMENT EURIBOR + 2 % WITH SWAP-AGREEMENT 8 %

% FIM % FIM % FIM % FIM

FIXED INTEREST RATE

(9 %)

TRUE INTEREST RATE

EXPECTED INTEREST RATE

TRUE INTEREST RATE

EXPECTED INTEREST RATE

CASE 2: CONSIDERING A SWAP IN THE FIRM MODEL

In your firm planning model, you have applied a fixed interest rate You can refine your analysis by assuming thatthe new loan taken during the first or second planning year is a bullet loan to be repaid by the end of the planninghorizon and that this loan may be swapped. Interest is paid twice a year for the bullet loan.Change your model to account for a variable yearly interest rate.Would you be prepared to swap for a floating interest rate given the conditions stated below?

(1) You expect the yearly interest rate to change as follows:

year 5 year 6 year 7 year 8 year 9

floating rate:

(2) You assume that your strategic decisions remain unaltered. Is the swap attractive?

(3) You want to adapt your strategy to the fluctuating interest rate expectations. Is the swap profitable now?

fyear5 + 1% fyear5 fyear5 - 1% fyear5 - 1.5% fyear5 - 1%

CASE 2: CONSIDERING A SWAP IN THE FIRM MODEL

In your firm planning model, you have applied a fixed interest rate You can refine your analysis by assuming thatthe new loan taken during the first or second planning year is a bullet loan to be repaid by the end of the planning

Would you be prepared to swap for a floating interest rate given the conditions stated below?

(3) You want to adapt your strategy to the fluctuating interest rate expectations. Is the swap profitable now?