15. An Example of an Interest Rate Swap Bank A The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years and we will pay you 10 3/8% on $10 million for 5 years Swap Bank LIBOR – 1/8% 10 3/8%
16. An Example of an Interest Rate Swap Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of - 10 3/8 + 10 + ( LIBOR – 1/8 ) = LIBOR – ½ % which is ½ % better than they can borrow floating without a swap. 10% ½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Swap Bank Bank A LIBOR – 1/8% 10 3/8%
17. An Example of an Interest Rate Swap Company B The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank 10 ½% LIBOR – ¼%
18. An Example of an Interest Rate Swap They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - ( LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. LIBOR + ½% Here’s what’s in it for B: ½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank Company B 10 ½% LIBOR – ¼%
19. An Example of an Interest Rate Swap The swap bank makes money too. ¼% of $10 million = $25,000 per year for 5 years. LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼ Swap Bank Company B Bank A 10 ½% LIBOR – ¼% LIBOR – 1/8% 10 3/8%
20. An Example of an Interest Rate Swap Swap Bank Company B Bank A B saves ½% A saves ½% The swap bank makes ¼% 10 ½% LIBOR – ¼% LIBOR – 1/8% 10 3/8%
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24. An Example of a Currency Swap Firm B Swap Bank Firm A $9.4% $8% £12% £11% $8% £12%
25. An Example of a Currency Swap $8% £12% Firm B Swap Bank Firm A $9.4% A’s net position is to borrow at £11% A saves £.6% £11% $8% £12%
26. An Example of a Currency Swap $8% £12% Firm B Swap Bank Firm A $9.4% B’s net position is to borrow at $9.4% B saves $.6% £11% $8% £12%
27. An Example of a Currency Swap $8% £12% Firm B The swap bank makes money too: 1.4% of $16 million (= 9.4% - 8%) financed with 1% of £10 million (=11% - 12%) per year for 5 years. Swap Bank Firm A $9.4% £11% $8% £12%
28. An Example of a Currency Swap $8% £12% Firm B The swap bank makes money too: -1% of £10 million = -£100,000 = -$160,000 per year for 5 years. The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap). 1.4% of $16 million = $224,000 per year for 5 years. Swap Bank Firm A $9.4% £11% $8% £12%
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35. Payoff Diagrams: An Example Exhibit 19.14 Payoff diagram for buying a put option (long put)