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    Chapter 7 Hull Swaps

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    Hazel Gayle De Perio
    This document discusses interest rate swaps and how they can be used to transform liabilities and assets. It provides an example of how a plain vanilla interest rate swap works, where one party agrees to pay a fixed interest rate in exchange for a floating rate from the other party. It also gives illustrations of how Microsoft and Intel could use swaps to transform Microsoft's floating rate borrowings into a fixed rate and Intel's fixed rate borrowings into a floating rate. The valuation of interest rate swaps is also briefly discussed.

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    Chapter 7 Hull Swaps

    Uploaded by

    Hazel Gayle De Perio
    82 views1 page
    This document discusses interest rate swaps and how they can be used to transform liabilities and assets. It provides an example of how a plain vanilla interest rate swap works, where one party agrees to pay a fixed interest rate in exchange for a floating rate from the other party. It also gives illustrations of how Microsoft and Intel could use swaps to transform Microsoft's floating rate borrowings into a fixed rate and Intel's fixed rate borrowings into a floating rate. The valuation of interest rate swaps is also briefly discussed.

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    CHAPTER 7 HULL SWAPS

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    This document discusses interest rate swaps and how they can be used to transform liabilities and assets. It provides an example of how a plain vanilla interest rate swap works, where one party agrees to pay a fixed interest rate in exchange for a floating rate from the other party. It also gives illustrations of how Microsoft and Intel could use swaps to transform Microsoft's floating rate borrowings into a fixed rate and Intel's fixed rate borrowings into a floating rate. The valuation of interest rate swaps is also briefly discussed.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    82 views1 page

    Chapter 7 Hull Swaps

    Uploaded by

    Hazel Gayle De Perio
    This document discusses interest rate swaps and how they can be used to transform liabilities and assets. It provides an example of how a plain vanilla interest rate swap works, where one party agrees to pay a fixed interest rate in exchange for a floating rate from the other party. It also gives illustrations of how Microsoft and Intel could use swaps to transform Microsoft's floating rate borrowings into a fixed rate and Intel's fixed rate borrowings into a floating rate. The valuation of interest rate swaps is also briefly discussed.

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    CHAPTER 7: SWAP VERSATILITY OF SWAPS

    1. Transforming Liabilities
     Over the counter derivatives agreement between
    2 companies to exchange cash flows in the
    future
     Agreement defines (1) dates when cash flows
    are to be paid, (2) how these are calculated
     Difference with forwards: Microsoft Cash Flows
    o Lead to cash-flow exchanges taking a) pays LIBOR plus 0.1% to outside lenders
    place on several future dates b) receives LIBOR under terms of swap
    INTEREST RATE SWAPS c) pays 5% under terms of swap
    Net interest payment: LIBOR + 0.1% - LIBOR +
    a) PLAIN VANILLA INTEREST RATE SWAP
    5.0% = 5.1%
     Company agrees to pay cash flows EQUAL to
    interest at a predetermined fixed rate on a Effect: transformed borrowings at a floating rate
    “notional” principal for a predetermined no. of (LIBOR + 0.1%) to a fixed rate of 5.1%
    years
     In return it receives interest at a floating rate Intel Cash Flows
    (LIBOR) on the same notional principal for the a) pays 5.2% to outside lenders
    same period of time b) receives 5.0% under terms of swap
    c) pays LIBOR under terms of swap
    Recall:
    Net interest payment: 5.2% - 5.0% + LIBOR =
    LIBOR – rate of interest at which a bank is prepared to LIBOR + 0.2% (20 basis pts)
    lend money to other banks that have an AA credit rating
    Effect: transformed borrowings at a fixed rate of
    Illustration: 5.2% to a floating rate (LIBOR + 20 basis points)

     3 year swap initiated on Mar 5, 2013


     Parties: Microsoft and Intel 2. Transforming Assets
     Microsoft agrees to pay Intel an interest rate of
    5% per annum on a principal of $100 million
     Intel agrees to pay Microsoft the 6-month LIBOR
    on the same principal
     Payments are exchanged every 6 months
     5% interest rate is quoted with semi-annual
    compounding
    Microsoft Cash Flows
    a) receives 4.7% on the bonds
    b) receives LIBOR under terms of swap
    c) pays 5% under terms of swap
    Net interest income: LIBOR minus 30 basis points

    Intel Cash Flows


    a) receives LIBOR - 0.2% on the bonds
    b) pays LIBOR under terms of swap
    c) receives 5% under terms of swap
    Net interest income: 4.8%

    VALUATION OF INTEREST RATE SWAPS

    1. Calculate forward rates for each of the LIBOR


    Microsoft has longed a floating rate bond rates that will determine swap cash flows.
    (bought/received the rate), and shorted a fixed rate bond 2. Calculate the swap cash flows on the
    (sold/pays the rate). assumption that LIBOR rates will EQUAL
    forward rates
    3. Discount the swap cash flows at the risk free
    rate.

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