Financial Instruments: Interest Rate Caps Currency Swaps
Financial Instruments: Interest Rate Caps Currency Swaps
Financial Instruments: Interest Rate Caps Currency Swaps
FINANCIAL INSTRUMENTS
1. Interest Rate Caps 2. Currency Swaps
Where, D =
NP = LPP =
Dummy variable that takes value +1 if dealer is cap seller and -1 if dealer is cap purchaser. Notional principal Length of the payment period
EXAMPLE
Date of purchasing cap Tenor Reference rate Ceiling rate Notional principal Settlement dates :15/8/2011 :5 years :6-M LIBOR :10% :$50 million :15th February and 15thAugust
15/08/2012
15/02/2013 15/08/2013 15/02/2014 15/08/2014 15/02/2015 15/08/2015 15/02/2016 15/08/2016 TOTAL
9.89
9.24 8.56 9.78 10.18 10.94 12.34 11.08 9.67
10
10 10 10 10 10 10 10 10
182/360
183/360 182/360 183/360 182/360 183/360 182/360 184/360 184/360
ADVANTAGES
DISADVANTAGES
Suitable when risk exposure spans multiple periods. Allows investor to benefit from interest rate changes while also limiting downside losses. Guarantees the investors maximum interest expenses. Can be sold at any time.
The buyer must pay the premium. Lower the ceiling rate, higher shall be the premium.
CURRENCY SWAPS
First currency swap engineered in London in 1979 Salmon Brothers put together currency swap involving the World Bank and IBM.
FEATURES
Two payment streams being exchanged denominated in different currencies. Exchange of principal at the beginning & reexchange at the termination.
COMPANY A REQUIREMENT S FRANCS FUNDING COMPANY B AUSTRALIAN DOLLAR FUNDING
16%
10%
10
11
Spot exchange rate : 5 Francs per 1 AUD Execution of deal worth 100 million AUD. Company A enters into swap with bank @ 15.2% and company B @ 10.2%. Thus, effective savings of both companies @ 0.8%.
TIME TRANSA COMPA CTION NY B BANK COMPA NY A
Original loan
A to Bank Bank to B
500 million
(500)
500 (500)
500
12
ADVANTAGES
DISADVANTAGES
Access to market with cheaper sources of funds. Reduction in exchange risk exposures.