swap
DESCRIPTION
SwapTRANSCRIPT
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?