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CHAPTER 16

CHAPTER 16. SPECIAL FINANCING VEHICLES. CHAPTER OVERVIEW. I. Interest Rate and Currency Swaps II. Structured Notes III. Interest Rate Forwards and Futures IV. International Leasing V. LDC Debt-Equity Swaps. I. Interest Rate and Currency Swaps. I. Interest Rate and Currency Swaps

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CHAPTER 16

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  1. CHAPTER 16 SPECIAL FINANCING VEHICLES

  2. CHAPTER OVERVIEW • I. Interest Rate and Currency Swaps • II. Structured Notes • III. Interest Rate Forwards and Futures • IV. International Leasing • V. LDC Debt-Equity Swaps

  3. I. Interest Rate and Currency Swaps • I. Interest Rate and Currency Swaps • A. Basic Features: • 1. Explosive growth in swap market • 2. Two types of swaps: • - interest rate

  4. Interest Rate Swaps • B. Interest Rate Swaps • 1. Definition: • two-party agreement • to exchange interest payments • for a specific maturity • based on a notional principal

  5. Interest Rate Swaps • 2. Notional principal • Definition: the reference amount used to calculate swap interest payments • Not the amount repaid by either counterparty

  6. Interest Rate Swaps • C. Swap Motivations • 1. Risk-reducing potential • 2. Cost savings • 3. Exploit comparative advantages enjoyed by different borrowers in different financial markets

  7. Interest Rate Swaps • D. Other Interest- Rate Swap Features: • 1. No principal ever changes hands • 2. Maturities: • 1 - 15 years possible • 2 - 10 years typical

  8. Interest Rate Swaps • 3. Two Types of Interest-Rate Swaps • a. Coupon Swaps • one counterparty pays a fixed rate • second counterparty pays a floating rate • floating rate resets periodically based on a designated index

  9. Interest Rate Swaps • 3. Two Types of Interest-Rate Swaps (continued) • b. Basis swap • two counterparties exchange floating interest payments based on the difference in reference rates

  10. Interest Rate Swaps • E. The Classic Swap Transaction • - an example • 1. Assumptions • Counterparty A: BBB-rated credit • Counterparty B: AAA-rated credit • Fixed-Rates Available • For A, 8.5% is best possible • For B, 7.0% is best possible

  11. Interest Rate Swaps • 1. Assumptions (continued) • Floating Rates Available • For A 6-month LIBOR + 0.5% • For B 6-month LIBOR

  12. Interest Rate Swaps • E. The Classic Swap: Step-by-step • Step 1: A receives a $100 million loan at LIBOR+50 points • from a syndicate of floating- • rate lenders (simultaneously) • B issues a $100 million bond for 5 years fixed at 7%

  13. THE CLASSIC SWAP (PART A) • STEP ONE: COUNTERPARTY B COUNTERPARTY A Lend $100 million 5-year with resets Floating-rate Lenders BOND MARKET Issue $100 million @7% for 5 years

  14. Interest Rate Swaps • Step 2: The Swap Agreement (Part A) • A borrows $100 million from BigBank and agrees to pay 7.35% for 5 years (.0735 x $100 million)

  15. THE CLASSIC SWAP (PART A) • STEP ONE: $100 M at 7.35% BIGBANK COUNTERPARTY A Floating-rate Lenders Lend $100 million 5-year with resets

  16. Interest Rate Swaps • In exchange for depositing its • $100 million floating-rate loan proceeds with BigBank, the Bank agrees to pay Counterparty A at the 6-month LIBOR rate (resets to match the original loan resets)

  17. THE CLASSIC SWAP (PART A) • STEP ONE: $100 M at 7.35% BIGBANK COUNTERPARTY A Deposit earns 6-mo LIBOR Floating-rate Lenders Lend $100 million 5-year with resets

  18. Interest Rate Swaps • The results from Part A: • Counterparty A has effectively borrowed at a fixed rate of 7.35% when otherwise the best the could have received in the fixed-rate market was 8.5%

  19. Interest Rate Swaps • Step 2: The Swap Agreement (Part B) • B borrows from BigBank at the 6 month LIBOR floating rate for 5 years • In exchange for the deposit of B’s bond proceeds of $100 million, BigBank agrees to pay B at 7.25%

  20. THE CLASSIC SWAP (PART B) • STEP TWO: Borrow at LIBOR BIGBANK COUNTERPARTY A COUNTERPARTY B Floating-rate Lenders BOND MARKET Deposit at 7.25%

  21. Interest Rate Swaps • The Result from Part B: • Counterparty B has swapped a fixed-rate loan for a floating-rate loan with an effective cost of LIBOR - .25% when otherwise the best the could have obtained in the floating-rate market was a LIBOR-only loan.

  22. Interest Rate Swaps • Part C: The Gains to BigBank from the Swaps • BigBank: • Receives 7.35% • Pays (7.25%) • Receives LIBOR • Pays (LIBOR) • Nets .01%

  23. Interest Rate Swaps • Part C: The Gains to BigBank from the Swap (continued) • BigBank receives • .001 x the notional principal • ($100 million) • = $100,000 annually for 5 years

  24. Interest Rate Swaps • F. Cost Savings • CounterpartyNormalSwapNet • A 8.5% 7.85 .65 • B LIBOR L-.25 .25 • BigBank .10 • Total 1.00

  25. Currency Swaps • G. Currency Swaps • 1. Definition: • an exchange of debt-service obligations • denominated in one currency • purpose: • for the service on an agreed upon principal amount of debt denominated in another

  26. Currency Swaps • 2. Motivation for Currency Swaps • a. Replaces parallel loan • b. Solve two potential problems: • 1.) If no right of offset, default • by one party does not release the other from making payments. • Swaps have right of offset.

  27. Currency Swaps • 2). Parallel loans remain on the balance sheet whereas a currency swap does not

  28. Currency Swaps • 3. Difference between interest-rate and • Currency swaps: • a. Currency swaps have an exchange of principal at predetermined exchange rates

  29. Interest-Rate and Currency Swaps • H. Economic Advantages of Swaps • 1. Overcome barriers when they exist to effective arbitrage such as • legal restrictions on forwards • different perceptions by investors of the creditworthiness of the two counterparties • tax differentials

  30. Interest-Rate and Currency Swaps • H. Economic Advantages of Swaps (continued) • 2. They provide long-term financing in foreign currencies

  31. II. Structured Notes • II. Structured Notes • A. Definition: • interest-bearing securities whose interest payments are by a formula set in advance • B. Formula • may be tied to a variety of different often complex factors

  32. Structured Notes • C. Purpose of Structured Notes • 1. They allow firms to speculate on • the direction, range, and volatility of interest rates • 2. They also can be used for hedging purposes

  33. Structured Notes • D. Types of Structured Notes • 1. Inverse floaters • 2. Step-ups • 3. Step-downs

  34. III. Interest Rate Forwards and Futures • III. Interest Rate Forwards and Futures • A. Include: • 1. Forward forwards • 2. Forward rate agreements • 3. Eurodollar futures

  35. Interest Rate Forwards and Futures • B. Forward Forwards • 1. Definition: • a contract that fixes an interest rate today on a future loan or deposit • 2. Contract specifies • interest rate • principal amount • start and ending dates of future interest rate period

  36. Interest Rate Forwards and Futures • C. Forward Rate Agreements • 1. Definition: • a cash-settled, over-the-counter • forward contract that allows • a fixed interest rate • the rate to be applied in the future on some notional principal amount • the parties to exchange interest payments

  37. Interest Rate Forwards and Futures • D. Eurodollar Futures • 1. Definition: • a cash-settled futures contract on a three-month, $1 million Eurodollar deposit that pays LIBOR • 2. Features are similar to currency futures

  38. IV. International Leasing • IV. International Leasing • A. Purposes • 1. To defer and avoid taxes • 2. To safeguard firm’s foreign subsidiary assets • 3. To avoid currency controls

  39. International Leasing • B. Types of Leases • 1. Operating Lease (true lease) • ownership and the use of the asset are separated • agreement covers only part of the useful life of the asset

  40. International Leasing • B. Types of Leases • 2. Financial lease • extends over most of the economic life of the asset • noncancelable • if cancelable, it requires substantial penalty to the lessor • in effect, lessor borrows money and then purchases the asset

  41. if a financial lease, lessee allowed tax depreciation for the purchase price tax deduction for the interest factorlessor not entitled to tax benefits International Leasing • 3. Tax Factors • a lease that qualifies as a true lease for tax purposes is called a tax- oriented lease entitling lessee to • deduct full value of lease payments

  42. International Leasing • if a financial lease, lessee allowed • tax depreciation for the purchase price • tax deduction for the interest factor • lessor not entitled to tax benefits

  43. V. LDC Debt-Equity Swaps • V. LDC Debt-Equity Swaps • A. The LDC Debt-Equity Market • 1. enables investors to purchase the external debt of less- developed countries (LDC) to • acquire equity or domestic • currency in those same markets

  44. LDC Debt-Equity Swaps • B. Types of Debt Swaps and Rationale • 1. LDC loans sell at deep discounts to their face value • 2. Substantial variation can occur across countries

  45. LDC Debt-Equity Swaps • 3. Investors buy loans in expectation that credit ratings will increase • 4. Arbitrage opportunities occur. The market offers a more favorable exchange rate that do official currency markets.

  46. LDC Debt-Equity Swaps • C. Costs and Benefits of Debt Swaps • 1. Debt swaps and inflation • 2. Impact on capital Formation • 3. Effect on privatization

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