1. DERIVATIVES, AND RISK MANAGEMENT,
LEFT-HAND FINANCING, AND
LEVERAGED BUYOUT
Group 1
Jerold Saddi
Pamela Bernabe
Juliet delos Santos
Jenelle Canonizado
Elvin Lee

2. Learning Objectives:
 After this session the FINMAN students
would be able to:
 Know all necessary concepts regarding
derivatives
 Know all various left-hand financing schemes,
including their advantages and disadvantages
 Know the mechanics of Leveraged buyout, its
use, it’s advantages and disadvantages
June 30, 2012

3. What are derivatives?
 Are financial instrument that
“derive” their value from
contractually required cash flows
from some other security or
index.
June 30, 2012

4. Example
http://www.youtube.com/watch?v=
FLGRPYAtReo
June 30, 2012

5. What are the essential features of a
derivative?
 A derivative is a financial instrument
 Values changes in response to the changes in
UNDERLYING variables.
 No or minimum initial net investment
 Settled at a future date by a net cash
payment / settlement
June 30, 2012

6. What are the kinds/examples of
derivatives?
 Option Contract
 Forward Contract
 Futures Contract
 Foreign Currency Exchange Contract
 Interest Rate Swap
June 30, 2012

7. Accounting for Derivatives
 Are to be considered as either assets or
liabilities and should be reported in the
balance sheet at fair value.
 Unrealized gain or loss from fedging
transactions is presented depending on
the type of hedging.
 Under the Fair Value hedge method – part of
income
 Under Cash Flow Hedge Method – part of
EQUITY
June 30, 2012

8. For foreign entity investment:
 Changes in fair Value determined to be an
effective hedge are recognized in
EQUITY.
 The ineffective portion of the changes in
fair value are recognized in EARNINGS
IMMEDIATELY if the hedging instrument is
a derivative.
June 30, 2012

9. Why do derivatives exist?
 Hedging - Pertains to designating one or
more hedging instruments so that their
change in fair value is an offset, in whole
or in part, to the change in fair value or
cash flows of a hedged item.
http://www.youtube.com/watch?v
=kBtrxAjtG04
June 30, 2012

10. FORWARD CONTRACT
 A transaction in which a seller agrees to
deliver a specific commodity to a buyer at
some point in the future.
Read more:
http://www.investorwords.com/2060/forward_
June 30, 2012

11. Example
June 30, 2012

12. Call/ put Options
Financial Futures
June 30, 2012
Pamela Bernabe

13. OPTIONS
 A derivatives financial instrument that specifies
a contract giving its owner the right to buy or
sell an asset at a fixed price on or before a given
date.
 Its also a unique type of financial contract
because they give the buyer the right, but not
the obligation, to do something.
 The buyer uses the option only if it is
adventageous to do so; otherwise the option can
be thrown away
 Give the marketplace opportunities to adjust risk
or alter income streams that would otherwise
June 30, not be available
2012

14. LOW STRIKE
Thales – ancient OLIVE SEASON –
Greek philosopher HIGH
June 30, 2012

15. EXAMPLE
 Supposedly the first option buyer in the
world was the ancient Greek
mathematician and philosopher Thales of
Miletus. On a certain occasion, it was
predicted that the season's olive harvest
would be larger than usual, and during the
off-season he acquired the right to use a
number of olive presses the following
spring. When spring came and the olive
harvest was larger than expected he
exercised his options and then rented the
June 30, 2012
presses out at much higher price than he

16. OPTION TERMINOLOGY
• Option Seller - One who gives/writes the option. He has an
obligation to perform, in case option buyer desires to exercise
his option.
• Option Buyer - One who buys the option. He has the right to
exercise the option but no obligation.
• Call Option - Option to buy.
• Put Option - Option to sell.
Call Option Put Option
Option Buyer Buys the right to buy the Buys the right to sell the
underlying asset at the underlying asset at the Strike
Strike Price Price
Option Seller Has the obligation to sell Has the obligation to buy the
the underlying asset to the underlying asset from the
option holder at the Strike option holder at the Strike
Price Price
June 30, 2012

17. OPTION TERMINOLOGY
• American Option - An option which can be
exercised anytime on or before the expiry
date.
• Strike Price/ Exercise Price - Price at which
the option is to be exercised.
• Expiration Date - Date on which the option
expires.
• European Option - An option which can be
exercised only on expiry date.
JuneExercise
• 30, 2012 Date - Date on which the option gets

18. CALL OPTIONS
A call option gives you the right to buy
within a specified time period at a specified
price
 The owner of the option pays a cash
premium to the option seller in exchange
for the right to buy
June 30, 2012

19. PRACTICAL EXAMPLE
OF A CALL OPTION
June 30, 2012

20. CALL OPTIONS -
ILLUSTRATION
 An investor buys one European Call option on one share
of Neyveli Lignite at a premium of Rs.2 per share on 31
July. The strike price is Rs.60 and the contract matures on
30 September. It may be clear form the graph that even in
the worst case scenario, the investor would only lose a
maximum of Rs.2 per share which he/she had paid for the
premium. The upside to it has an unlimited profits
opportunity.
On the other hand the seller of the call option has a payoff
chart completely reverse of the call options buyer. The
maximum loss that he can have is unlimited though a profit
of Rs.2 per share would be made on the premium payment
June 30, 2012
by the buyer.

21. June 30, 2012

22. PUT OPTIONS
A put option gives
you the right to sell
within a specified
time period at a
specified price
 It
is not necessary to
own the asset before
acquiring the right to
sell it
June 30, 2012

23.  An investor buys one European Put Option
on one share of Neyveli Lignite at a premium
of Rs. 2 per share on 31 July. The strike
price is Rs.60 and the contract matures on
30 September. The adjoining graph shows
the fluctuations of net profit with a change in
the spot price.
June 30, 2012

24. June 30, 2012

25. CALL/PUT OPTIONS
Call Option Put Option
Option Buyer Buys the right to buy the Buys the right to sell the
underlying asset at the Strike underlying asset at the Strike
Price Price
Option Seller Has the obligation to sell the Has the obligation to buy the
underlying asset to the option underlying asset from the option
holder at the Strike Price holder at the Strike Price
June 30, 2012

26. STANDARDIZED
OPTION CHARACTERISTICS
 All exchange-traded options have standardized
expiration dates
 The Saturday following the third Friday of designated
months for most options
 Investors typically view the third Friday of the month
as the expiration date
 The striking price of an option is the predetermined
transaction price
In multiples of $2.50 (for stocks priced $25.00 or
below) or $5.00 (for stocks priced higher than $25.00)
 There is usually at least one striking price above and
one below the current stock price
June 30, 2012

27. STANDARDIZED
OPTION CHARACTERISTICS
 Puts and calls are based on 100 shares of the
underlying security
 The underlying security is the security that the option
gives you the right to buy or sell
 It is not possible to buy or sell odd lots of options
June 30, 2012

28. FINANCIAL FUTURES
Forwards – a contract that is customized between
two entities, where settlement takes place on a
specific date in the future at today’s pre-agreed
price
Futures – an agreement between two parties to
buy or sell an asset to a certain time in the
future at a certain price.
- it is also a special types of forward
contracts in the sense that the former
standardized exchange-traded contracts.
June 30, 2012

29. SIMPLE EXAMPLE
 If you agree in April with your Aunt Sue that you will
buy two pounds of tomatoes from her garden for $5,
to be delivered to you when they're ripe in July, you
and Sue just entered into a futures contract.
June 30, 2012

30. FINANCIAL FUTURES
 A financial future is a futures contract on a short term
interest rate (STIR). Contracts vary, but are often
defined on an interest rate index such as 3-month
sterling or US dollar LIBOR.
 They are traded across a wide range of currencies,
including the G12 country currencies and many others.
 The assets often traded in futures contracts include
commodities, stocks, and bonds. Grain, precious metals,
electricity, oil, beef, orange juice, and natural gas are
traditional examples of commodities, but foreign
currencies, emissions credits, bandwidth, and certain
financial instruments are also part of today's commodity
markets.
June 30, 2012

31. FINANCIAL FUTURES
 Some representative financial futures contracts are:
United States
 90-day Eurodollar *(IMM)
 1 mo LIBOR (IMM)
 Fed Funds 30 day (CBOT)
Europe
 3 mo Euribor (Euronext.liffe)
 90-day Sterling LIBOR (Euronext.liffe)
 Euro Sfr (Euronext.liffe)
Asia
 3 mo Euro yen (TIF)
 90-day Bank Bill (SFE)
where
 IMM is the International Money Market of the Chicago Mercantile
Exchange
 CBOT is the Chicago Board of Trade
 TOCOM is the Tokyo Commodity Exchange
 SFE is the Sydney futures exchange
June 30, 2012

32. COMPARISON OF FUTURES
AND FORWARD
Futures Forward
Amount Standardized Negotiated
Delivery Date Standardized Negotiated
Counter-party Clearinghouse Bank
Collateral Margin Acct. Negotiated
Market Auction Market Dealer Market
Costs Brokerage and Bid-ask spread
exchange fees
Liquidity Very liquid Highly illiquid
Regulation Government Self-regulated
June Location
30, 2012 Central Worldwide
exchange

33. ADVANTAGE AND DISADVANTAGE
OF FINANCIAL FUTURES
 Advantages
 Small Contract Size
 Easy liquidation
 Well organized and stable market (no risk of default)
 Disadvantages
 Limited number of currencies (but think about how one
futures might be a close hedge against another currency)
 Rigid contract size
 Fixed expiration dates (but if you can get close, it doesn’t
matter all that much).
June 30, 2012

34. THERE ARE TWO TYPES OF
ORGANIZATIONS THAT FACILITATE
FUTURES TRADING:
Exchange
Exchanges are non-profit or for-profit
organizations that offer standardized futures
contracts for physical commodities, foreign
currency and financial products.
Clearinghouse
A clearinghouse is agency associated with an
exchange, which settles trades and regulates
delivery. Clearinghouses guarantee the
fulfillment of futures contract obligations by all
parties involved.
June 30, 2012

35. AN EXAMPLE:
90-DAY EURODOLLAR TIME DEPOSIT
FUTURES
 Eurodollar futures contracts are traded on the
International Monetary Market (IMM), a division
of the Chicago Mercantile Exchange.
 The underlying asset is a Eurodollar time deposit
with a 3-month maturity.
 Eurodollar rates are quoted on an interest-bearing
basis, assuming a 360-day year.
 Each Eurodollar futures contract represents $1 million
of initial face value of Eurodollar deposits maturing
three months after contract expiration.
 Forty separate contracts are traded at any point in time,
as contracts expire in March, June, September and
December
June 30, 2012

36. AN EXAMPLE:
90-DAY EURODOLLAR TIME DEPOSIT FUTURES
 Eurodollar futures contracts trade
according to an index that equals 100
percent minus the futures interest rate
expressed in percentage terms.
 An index of 91.50 indicates a futures rate of 8.5
percent.
 Each basis point change in the futures rate
equals a $25 change in value of the contract
(0.0001 x $1 million x 90/360).
June 30, 2012

37. 3 -M O . E U R O D O L L A R (C M E )-$ 1 M IL L IO N ; P T S O F 1 0 0 %
EURODOLLAR
Y ie ld O p en
O p e n H ig h L o w S e ttle C h g S e ttle C h g I n te r e s t
J u ly 9 4 .3 0 9 4 .3 1 9 4 .3 0 9 4 .3 1 ..... 5 .6 9 ..... 3 1 ,1 8 2
FUTURES A ug
S ept
O c t
9 4 .3 1 9 4 .3 1 9 4 .3 1 9 4 .3 1
9 4 .3 1 9 4 .3 1 9 4 .3 0 9 4 .3 1
..... ..... ..... 9 4 .2 7
.....
.....
.....
5 .6 9
5 .6 9
5 .7 3
.....
..... 5 1 0 ,6 0 6
.....
9 ,3 8 0
2 ,1 9 2
N ov ..... ..... ..... 9 4 .2 7 ..... 5 .7 3 ..... 672
D ec 9 4 .2 6 9 4 .2 7 9 4 .2 4 9 4 .2 6 ..... 5 .7 4 ..... 3 8 7 ,5 3 1
M r9 9 9 4 .3 1 9 4 .3 1 9 4 .2 8 9 4 .3 1 ..... 5 .6 9 ..... 3 2 5 .3 4 2
J une 9 4 .3 0 9 4 .3 0 9 4 .2 8 9 4 .2 8 ..... 5 .7 2 ..... 2 6 9 ,6 4 1
 The first column indicates the S ept 9 4 .2 6 9 4 .2 7 9 4 .2 6 9 4 .2 6 ..... 5 .7 4 ..... 2 2 9 ,0 7 5
settlement month and year. D ec
M r0 0
9 4 .1 7 9 4 .1 7 9 4 .1 5 9 4 .1 6
9 4 .2 1 9 4 .2 1 9 4 .2 0 9 4 .2 1
.....
.....
5 .8 4
5 .7 9
..... 1 9 0 ,8 3 2
..... 1 5 9 ,1 3 9
J une 9 4 .1 8 9 4 .1 8 9 4 .1 7 9 4 .1 8 ..... 5 .8 2 ..... 1 4 3 ,0 0 7
 Each row lists price and yield S ept 9 4 .1 7 9 4 .1 7 9 4 .1 5 9 4 .1 6 ..... 5 .8 4 ..... 8 7 ,2 5 1
data for a distinct futures D ec
M r0 1
9 4 .0 9 9 4 .0 9 9 4 .0 8 9 4 .0 9
9 4 .1 2 9 4 .1 3 9 4 .1 2 9 4 .1 2
.....
.....
5 .9 1
5 .8 8
.....
.....
7 3 ,2 0 5
6 7 ,2 2 2
contract that expires J une
S ept
9 4 .1 1 9 4 .1 1 9 4 .1 0 9 4 .1 1
9 4 .1 0 9 4 .1 0 9 4 .0 9 9 4 .1 0
.....
.....
5 .8 9
5 .9 0
.....
.....
5 8 ,3 4 1
4 7 ,3 6 2
sequentially every three D ec 9 4 .0 3 9 4 .0 4 9 4 .0 2 9 4 .0 3 ..... 5 .9 7 ..... 4 1 ,4 1 5
months. M r0 2
J une
9 4 .0 7 9 4 .0 7 9 4 .0 6 9 4 .0 7
9 4 .0 5 9 4 .0 6 9 4 .0 4 9 4 .0 5
.....
.....
5 .9 3
5 .9 5
.....
.....
4 6 ,0 1 2
4 5 ,8 1 5
 The next four columns report S ept
D ec
9 4 .0 4 9 4 .0 5 9 4 .0 4 9 4 .0 4
9 3 .9 7 9 3 .9 8 9 3 .9 6 9 3 .9 7
.....
.....
5 .9 6
6 .0 3
.....
.....
4 3 ,1 8 4
3 2 ,7 3 6
the opening price, high and low M r0 3
J une
9 4 .0 1 9 4 .0 1 9 4 .0 0 9 4 .0 1
9 3 .9 9 9 3 .9 9 9 3 .9 8 9 3 .9 9
.....
.....
5 .9 9
6 .0 1
.....
.....
2 8 ,8 1 2
2 0 ,3 7 3
price, and closing settlement S ept 9 3 .9 8 9 3 .9 8 9 3 .9 8 9 3 .9 8 ..... 6 .0 2 ..... 1 5 ,8 6 4
price. D ec
M r0 4
9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .9 1
9 3 .9 4 9 3 .9 4 9 3 .9 4 9 3 .9 4
.....
.....
6 .0 9
6 .0 6
.....
.....
8 ,7 4 4
7 ,5 0 5
 The next column, headed Chg, J une
S ept
..... ..... ..... 9 3 .9 1
9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .8 9
.....
.....
6 .0 9
6 .1 1
.....
.....
8 ,5 5 3
6 ,9 3 8
states the change in settlement D ec
M r0 5
.....
.....
.....
.....
..... 9 3 .8 2
..... 9 3 .8 5
.....
.....
6 .1 8
6 .1 5
.....
.....
7 ,3 9 7
5 ,5 7 6
price from the previous day. J une ..... ..... ..... 9 3 .8 3 ..... 6 .1 7 ..... 5 ,3 2 3
S ept ..... ..... ..... 9 3 .8 1 ..... 6 .1 9 ..... 4 ,2 5 0
 The two columns under Yield D ec ..... ..... ..... 9 3 .7 4 ..... 6 .2 6 ..... 3 ,7 3 5
convert the settlement price to M r0 6
J une
.....
.....
.....
.....
..... 9 3 .7 7
..... 9 3 .7 4
.....
.....
6 .2 3
6 .2 6
.....
.....
5 ,8 1 6
3 ,6 4 8
a Eurodollar futures rate as: S ept
D ec
.....
.....
.....
.....
..... 9 3 .7 2
..... 9 3 .6 5
.....
.....
6 .2 8
6 .3 5
.....
.....
4 ,7 0 9
5 ,3 3 1
100 - settlement price = futures M r0 7
J une
..... ..... ..... 9 3 .6 8 .....
9 3 .6 9 9 3 .6 9 9 3 .6 9 9 3 .6 6 1 .0 1 6 .3 4 2 .0 1
6 .3 2 ..... 4 ,0 7 5
4 ,2 0 5
rate S ept ..... ..... ..... 9 3 .6 4 1 .0 1 6 .3 6 2 .0 1 4 ,6 1 9
June 30, 2012
D ec ..... ..... ..... 9 3 .5 7 1 .0 1 6 .4 3 2 .0 1 3 ,6 8 0
M r0 8 ..... ..... ..... 9 3 .6 0 1 .0 1 6 .4 0 2 .0 1 3 ,4 0 6
J une ..... ..... ..... 9 3 .5 7 1 .0 1 6 .4 3 2 .0 1 295
E s t v o l 1 3 6 , 1 8 2 ; v o l F r i 2 2 7 , 5 8 8 ; o p e n i n t 2 , 9 6 31 ,19 19 , 66 ,4 5 .

38. SPECULATING WITH
FUTURES, LONG
 Buying a futures contract (today) is often referred to
as “going long,” or establishing a long position.
 Recall: Each futures contract has an expiration date.
 Every day before expiration, a new futures price is established.
 If this new price is higher than the previous day’s price, the
holder of a long futures contract position profits from this
futures price increase.
 If this new price is lower than the previous day’s price, the
holder of a long futures contract position loses from this
futures price decrease.
June 30, 2012

39. EXAMPLE I: SPECULATING IN
GOLD FUTURES
 You believe the price of gold will go up. So,
 You go long 100 futures contract that expires in 3 months.
 The futures price today is $400 per ounce.
 There are 100 ounces of gold in each futures contract.
 Your "position value" is: $400 X 100 X 100 =
$4,000,000
 Suppose your belief is correct, and the price of gold is
$420 when the futures contract expires.
 Your "position value" is now: $420 X 100 X 100 =
$4,200,000
Your "long" speculation has resulted in a gain of
June 30, 2012
$200,000

40. SPECULATING WITH
FUTURES, SHORT
 Selling a futures contract (today) is often called
“going short,” or establishing a short position.
 Recall: Each futures contract has an expiration
date.
 Every day before expiration, a new futures price is
established.
 If this new price is higher than the previous day’s price,
the holder of a short futures contract position loses
from this futures price increase.
 If this new price is lower than the previous day’s price,
the holder of a short futures contract position profits
from this futures price decrease.
June 30, 2012

41. EXAMPLE II: SPECULATING IN
GOLD FUTURES
 You believe the price of gold will go down. So,
 You go short 100 futures contract that expires in 3 months.
 The futures price today is $400 per ounce.
 There are 100 ounces of gold in each futures contract.
 Your "position value" is: $400 X 100 X 100 = $4,000,000
 Suppose your belief is correct, and the price of gold is $370
when the futures contract expires.
 Your “position value” is now: $370 X 100 X 100 = $3,700,000
Your "short" speculation has resulted in a gain of
$300,000
What would have happened if the gold price was $420?
June 30, 2012

42. INTEREST RATE SWAPS
June 30, 2012 Juliet Delos Santos

43. Swaps Contracts
 In a swap, two counterparties agree to a
contractual arrangement wherein they
agree to exchange cash flows at periodic
intervals.
 There are two types of interest rate
swaps:
 Single currency interest rate swap
 “Plain vanilla” fixed-for-floating swaps are often just called
interest rate swaps.
 Cross-Currency interest rate swap
 This is often called a currency swap; fixed for fixed rate debt
service in two (or more) currencies.
June 30, 2012

44. Swap Bank
A swap bank is a generic term to describe
a financial institution that facilitates swaps
between counterparties.
 The swap bank can serve as either a
broker or a dealer.
 As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap.
 As a dealer, the swap bank stands ready to accept either
side of a currency swap, and then later lay off their risk,
or match it with a counterparty.
June 30, 2012

45. Example: Interest Rate Swap
 Consider this example of a “plain vanilla”
interest rate swap.
 Bank A is a AAA-rated international bank
located in the U.K. and wishes to raise
$10,000,000 to finance floating-rate
Eurodollar loans.
 Bank A is considering issuing 5-year fixed-rate Eurodollar
bonds at 10 percent.
 It would make more sense to for the bank to issue
floating-rate notes at LIBOR (London Interbank
Offered Rate) to finance floating-rate Eurodollar loans.
June 30, 2012

46. Example: Interest Rate Swap (cont.)
 Firm B is a BBB-rated U.S.
company. It needs $10,000,000 to
finance an investment with a five-
year economic life.
 Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
 Alternatively, firm B can raise the money by issuing
5-year floating-rate notes at LIBOR + ½ percent.
 Firm B would prefer to borrow at a fixed rate.
June 30, 2012

47. Example: Interest Rate Swap (cont.)
The borrowing opportunities of the
two firms are:
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
June 30, 2012

48. Example: Interest Rate Swap (cont.)
Swap The swap bank makes this
offer to Bank A: You pay
Bank LIBOR – 1/8 % per year
10 3/8%
on $10M for 5 yrs. and we
LIBOR – 1/8%
will pay you 10 3/8% on
Bank $10M for 5 yrs.
A
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
June 30, 2012

49. Example: Interest Rate Swap (cont.)
½% of $10M = Here’s what’s in it for
$50K. That’s quite Swap Bank A: They can borrow
a cost savings per Bank externally at 10% fixed
yr. for 5 yrs. 10 3/8% and have a net
LIBOR – 1/8%
borrowing position of
Bank -10 3/8 + 10 + (LIBOR –
10%
A 1/8) =
LIBOR – ½ % which is ½
COMPANY B BANK A % better than they can
Fixed rate 11.75% 10% borrow floating without a
Floating rate LIBOR + .5% LIBOR swap.
June 30, 2012

50. Example: Interest Rate Swap (cont.)
The swap bank
makes this offer to Swap
company B: You Bank
pay us 10½% per 10 ½%
year on $10 LIBOR – ¼%
million for 5 years Company
and we will pay
you LIBOR – ¼ % B
per year on $10
million for 5 years. COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
June 30, 2012

51. Example: Interest Rate Swap (cont.)
Here’s what’s in it ½ % of $10M =
for B: Swap $50K that’s quite a
cost savings per yr. for
They can borrow Bank 5 yrs.
externally at 10 ½%
LIBOR + ½ % and have LIBOR – ¼%
a net borrowing position Company LIBOR
+ ½%
of 10½ + (LIBOR + ½ ) B
- (LIBOR - ¼ ) = 11.25%
which is ½% better than
COMPANY B BANK A
they can borrow floating.
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
June 30, 2012
25-51

52. Example: Interest Rate Swap (cont.)
The swap bank makes money too. ¼% of $10M=
Swap $25,000 per yr.
for 5 yrs.
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%
Bank Company
A LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 B
10 ½ - 10 3/8 = 1/8
¼
COMPANY B BANK A
Fixed rate 11.75% 10%
June 30, 2012 Floating rate LIBOR + .5% LIBOR
25-52

53. Example: Interest Rate Swap (cont.)
The swap bank makes ¼%
Swap
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%
Bank Company
A B
A saves ½% B saves ½%
COMPANY B BANK A
Fixed rate 11.75% 10%
June 30, 2012 Floating rate LIBOR + .5% LIBOR
25-53

54. Example: Currency Swap
 Suppose a U.S. MNC wants to finance a
£10M expansion of a British plant.
 They could borrow dollars in the U.S. where
they are well known and exchange for
dollars for pounds.
 This will give them exchange rate risk: financing a
sterling project with dollars.
 They could borrow pounds in the
international bond market, but pay a
premium since they are not as well known
abroad.
June 30, 2012

55. Example: Currency Swap (cont.)
 If they can find a British MNC with a
mirror-image financing need they may
both benefit from a swap.
 If the spot exchange rate is S0($/£) =
$1.60/£, the U.S. firm needs to find a
British firm wanting to finance dollar
borrowing in the amount of $16M.
June 30, 2012

56. Example: Currency Swap (cont.)
Consider two firms A and B: firm A is a
U.S.–based multinational and firm B is a
U.K.–based multinational.
Both firms wish to finance a project in each
other’s country of the same size. Their
borrowing opportunities are given in the
table below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
June 30, 2012

57. Example: Currency Swap (cont.)
A’s net position is to borrow at £11%
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
A savaes £.6%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
June 30, 2012

58. Example: Currency Swap (cont.)
B’s net position is to borrow at $9.4%
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
B saves $.6%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
June 30, 2012

59. Example: Currency Swap (cont.)
The swap bank makes money too: 1.4% of $16 million
Swap financed with 1% of
£10 million per year
Bank for 5 years.
$8% $9.4%
£11% £12%
$8% Firm At S0($/£) = $1.60/£, Firm £12%
A that is a gain of $64,000 B
per year for 5 years.
$ £ The swap bank faces
Company A 8.0% 11.6% exchange rate risk, but
Company B 10.0% 12.0% maybe they can lay it
June 30, 2012 off (in another swap).

60. Variations of Basic Swaps
 Currency Swaps
 fixed for fixed
 fixed for floating
 floating for floating
 amortizing
 Interest Rate Swaps
 zero-for floating
 floating for floating
 Exotica
 For a swap to be possible, two humans must like the idea. Beyond
that, creativity is the only limit.
June 30, 2012

61. Risks of Interest Rate and Currency Swaps
 Interest Rate Risk
 Interest rates might move against the swap bank after
it has only gotten half of a swap on the books, or if it
has an unhedged position.
 Basis Risk
 If the floating rates of the two counterparties are not
pegged to the same index.
 Exchange Rate Risk
 In the example of a currency swap given earlier, the
swap bank would be worse off if the pound
appreciated.
June 30, 2012
25-61

62. Risks of Interest Rate and Currency Swaps
 Credit Risk
 This is the major risk faced by a swap dealer—the risk
that a counter party will default on its end of the swap.
 Mismatch Risk
 It’s hard to find a counterparty that wants to borrow
the right amount of money for the right amount of
time.
 Sovereign Risk
 The risk that a country will impose exchange rate
restrictions that will interfere with performance on the
swap.
June 30, 2012

63. Pricing a Swap
A swap is a derivative security so
it can be priced in terms of the
underlying assets:
 How to:
 Plain vanilla fixed for floating swap gets valued
just like a bond.
 Currency swap gets valued just like a nest of
currency futures.
June 30, 2012

64. Derivatives Prevailing in the Philippine
Market
 Forward
 Swap (Interest or Asset)
 Options
 Credit-Linked Notes
 Structured Product –Structured Yield
Deposit
Source: BSP Circular 594
June 30, 2012

65. What is corporate risk management, and why
is it important to all firms?
 Corporate risk management relates to the
management of unpredictable events that
would have adverse consequences for the
firm.
 All firms face risks, but the lower those risks
can be made, the more valuable the firm,
other things held constant. Of course, risk
reduction has a cost.
June 30, 2012

66. Definitions of different types of
risk
 Speculative risks – offer the chance of a gain
as well as a loss.
 Pure risks – offer only the prospect of a loss.
 Demand risks – risks associated with the
demand for a firm’s products or services.
 Input risks – risks associated with a firm’s
input costs.
 Financial risks – result from financial
transactions.
June 30, 2012

67. Definitions of different types of risk
 Property risks – risks associated with loss of
a firm’s productive assets.
 Personnel risk – result from human actions.
 Environmental risk – risk associated with
polluting the environment.
 Liability risks – connected with product,
service, or employee liability.
 Insurable risks – risks that typically can be
covered by insurance.
June 30, 2012

68. What are the three steps of
corporate risk management?
1. Identify the risks faced by the firm.
2. Measure the potential impact of the
identified risks.
3. Decide how each relevant risk should
be handled.
June 30, 2012

69. What can companies do to minimize or
reduce risk exposure?
 Transfer risk to an insurance company by paying
periodic premiums.
 Transfer functions that produce risk to third
parties.
 Purchase derivative contracts to reduce input and
financial risks.
 Take actions to reduce the probability of
occurrence of adverse events and the magnitude
associated with such adverse events.
 Avoid the activities that give rise to risk.
June 30, 2012

70. Leasing and Other
Asset-Based
Financing
Corporate Financial Management 3e
Emery Finnerty Stowe
Modified for course use by Arnold R. Cowan
June 30, 2012

71. Lease Financing
 A lease is a rental agreement that extends for
one year or longer.
 The owner of the asset (the lessor) grants
exclusive use of the asset to the lessee for a fixed
period of time.
 In return, the lessee makes fixed periodic payments to
the lessor.
 At termination, the lessee may have the option to
either renew the lease or purchase the asset.
June 30, 2012
71

72. Types of Leases
 Full-service lease
 Lessor responsible for maintenance, insurance,
and property taxes.
 Net lease
 Lessee responsible for maintenance, insurance,
and property taxes.
June 30, 2012
72

73. Types of Leases
 Operating lease
 short-term
 may be cancelable
 Financial lease
 long-term
 similar to a loan agreement
June 30, 2012
73

74. Types of Lease Financing
 Direct leases
 Sale-and-lease-back agreements
 Leveraged leases
June 30, 2012
74

75. Direct Lease
Manufacturer
Lessee Lease
/ Lessor
or
Manufacturer
Lessee Lease
Lessor Sale of Asset
/ Lessor
June 30, 2012
75

76. Sale-and-Lease-Back
Sale of Asset
Lessee Lessor
Lease
June 30, 2012
76

77. Leveraged Lease
Manufacturer
Sale of Asset
Single Lien
Lender
Purpose Loan
Lessee Lease
Leasing Equity
Company Equity
Investor
June 30, 2012
77

78. Synthetic Leases
 Firms have used synthetic leases to get
the use of assets but keep debt off their
balance sheets.
 An unrelated financial institution invests
some equity and sets up a special-
purpose-entity that buys the assets and
leases it to the firm under an operating
lease.
 Since the Enron bankruptcy, firms have
been reluctant to use synthetic leases.
June 30, 2012
78

79. Advantages of Leases
 Efficient use of tax deductions and tax credits of
ownership
 Reduced risk
 Reduced cost of borrowing
 Bankruptcy considerations
 Tapping new sources of funds
 Circumventing restrictions
 debt covenants
 off-balance sheet financing
June 30, 2012
79

80. Disadvantages of Leasing
 Lessee forfeits tax deductions associated
with asset ownership.
 Lessee usually forgoes residual asset
value.
June 30, 2012
80

81. Valuing Financial Leases
 Basic approach is similar to debt refunding.
 Lease displaces debt.
 Missed lease payments can result in the lessor
 claiming the asset.
 filing lawsuits.
 forcing firm into bankruptcy.
 Risk of a firm’s lease payments are similar to
those of its interest and principal payments.
June 30, 2012
81

82. Project Financing
 Desirable when
 Project can stand alone as an economic unit.
 Project will generate enough revenue (net of
operating costs) to service project debt.
 Examples:
 Mines & mineral processing facilities
 Pipelines
 Oil refineries
 Paper mills
June 30, 2012
82

83. Project Financing Arrangements
 Completion undertaking
 Purchase, throughput, or tolling
agreements
 Cash deficiency agreements
June 30, 2012
83

84. Advantages and Disadvantages of
Project Financing
 Advantages
 Risk sharing
 Expanded debt capacity
 Lower cost of debt
 Disadvantages
 Significant transaction costs and legal fees
 Complex contractual agreements
 Lenders require a higher yield premium
June 30, 2012
84

85. Limited Partnership Financing
 Another form of tax-oriented financing.
 Allows the firm to “sell” the tax
deductions and credits associated with
asset ownership to the limited partners.
 Income (or loss) for tax purposes flows
through to the partners.
 Limited partners are passive investors.
 General partner operates the limited
partnership and has unlimited liability.
June 30, 2012
85

86. June 30, 2012

87. 87
Leveraged Buyouts (LBO)
•
LBOs are a way to take a public company private, or put a
company in the hands of the current management, MBO.
•
LBOs are financed with large amounts of borrowing (leverage),
hence its name.
•
LBOs use the assets or cash flows of the company to secure debt
financing, bonds or bank loans, to purchase the outstanding equity
of the company.
•
After the buyout, control of the company is concentrated in the
hands of the LBO firm and management, and there is no public
stock outstanding.

88. 88
History: LBO
•
Leveraged buyouts were a relatively obscure means of
financing large corporate acquisitions in the post WWII
period. The practice positively boomed in the 1980s,
with a combined $188 billion in acquisitions taking
place in 1988 alone. The term “hostile takeover” coined
during this period, it reflects the mixed feelings
towards LBO.

89. 89
Successful LBO Strategies
•
Finding cheap assets – buying low and
selling high (value arbitrage or multiple
expansion)
•
Unlocking value through restructuring:
–
Financial restructuring of balance sheet –
improved combination of debt and equity
–
Operational restructuring – improving
operations to increase cash flows

90. Key Terms and concepts regarding LBOs:
Transaction fee amortization. This reflects the capitalization and
•
amortization of financing, legal, and accounting fees associated with the
transaction.
- its like depreciation, is a tax-deductible noncash expense.
Interest Expense- For simplicity, interest expense for each tranche of
•
debt financing is calculated based on the yearly beginning balance of
each tranche.
•
Capitalization. Most leveraged buyouts make use of multiple tranches
of debt to finance the transaction. A simple transaction may have only
two tranches of debt, senior and junior. A large leveraged buyout will
likely be financed with multiple tranches of debt that could include
some or all of the following:
•
Revolving credit facility (revolver). This is a source of funds
that the bought-out firm can draw upon as its working capital
needs dictate.

91. •
Bank debt. Often secured by the assets of the bought-
ought firm, this is the most senior claim against the
cash flows of the business.
•
Mezzanine Debt – exists in the middle of the capital
structure and is junior to the bank debt incurred in
financing the leveraged buyout.
•
Subordinated or high yield notes (junk bonds) –
most junior source of debt financing and as such has
the highest interest rates.
•
Cash Sweep - is a provision of certain debt covenants
that stipulates that any excess cash generated by the
bought out business will be used to pay down
principal.
•
Exit Scenario – usually involves either a sale of
portfolio company or recapitalization.