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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 43
FOREIGN EXCHANGE MARKET'S SWAPS
We shall cover following topics in this hand out:
Calculating financial benefit ­ Interest rate Option
Interest rate caps and floor
Swaps
Interest rate swaps
Currency swaps
Calculating Financial Benefit ­ Interest Rate Option
Almost the calculation involved to reach at the gain or loss are the same as we did in equity or stock
options. As earlier stated that loss under option is generally limited to the cost of option paid to the option
seller. It is of immense importance to understand the scenario to perform calculations.
We take up borrowing scenario. The company or the firm intends to borrow in near future and anticipates
that interest rates will be up when it actually will utilize the loan amount. If interest rises then it will be
incurring more interest cost then present. Therefore, the firm will set up or buy the option against the rise
in interest rates and the option will be profitable or exercisable only if interest rate does increase.
The calculations are as under (assuming that interest rates have gone up):
Compute the interest rate using notional amount @ prevailing interest rate. This will be the rate at the time
of exercising the option, which is assumed higher than the agreed rate. (Interest Expense)
The second component is the cost of option. (Cost of Options)
Third line item in this calculation will be the receipt from the option seller. The notional amount is
multiplied with the difference between the prevailing interest rate and agreed rate, adjusted for the period of
loan. This is income of the option holder. (Receipt from Option)
If we sum
(Interest Expense) + (Cost of Options) - (Receipt from Option) = Net Interest Expense.
The next step will be to calculate the effective interest expense, which can be computed by dividing Net
Interest Expense by the loan amount. This effective interest rate is less than the rate prevailing in the
market.
Interest Rate Caps and Floor
Firms may borrow from a bank or deposit funds at variable rate of interest connected to some benchmark
rate like KIBOR in Pakistan or LIBOR (London Inter Bank Offered Rate) in international money markets.
When borrowing on variable interest rates, a firm may want to utilize option as hedging tool against the
unfavorable interest rate movements over the full term of loan or deposit.
Interest Rate Cap is a series of borrower option that sets a maximum interest rate for a medium term loan.
The cap holder has the right to exercise the option at each interest fixing date or rollover date for the loan.
Whenever an option is exercised within a cap agreement, there is cash payment from the seller of the cap to
the cap holder.
Interest rate floor is an option to limit interest rate to a given minimum.
This is a series of option for lenders setting minimum interest rate for medium term deposits. The floor
holder can exercise option at the dates given in the option.
Interest rate caps & floor are like normal options with a difference that in case the option is exercised the
cash settlement is made at the end of interest period and not in the beginning. Secondly, more than one
period is covered and this may be two to five years divided into three or six month periods. However, these
are very expensive options due to high premium cost.
Swaps
A swap is a contract between to parties to exchange their cash flows related to specific obligations for an
agreed period. A swap may be for interest rate or for currency.
A vanilla interest rate swap is a contract between two parties to exchange interest rates on a notional
amount at regular intervals. One party opts for interest payments based on the fixed interest rate and other
at variable rate. A swap may have life up to 30 years. Swaps are used to hedge interest rate risk on short
term as well as long-term instruments like bonds and loans.
A firm can use swaps to manage the mix of its fixed rate and floating rate debt obligations, without having
to change the underlying loans themselves. Swap allows the company to borrow at an effective fix rate
when it cannot do directly from the market due to its size.
143
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Corporate Finance ­FIN 622
VU
If a firm anticipates a rise or fall in the short-term interest rates compared to long term interest rate, it may
utilize swap to take more floating rate and less fixed rate debt obligations or the other way round.
In short, swap are used to exchange floating rate interest payments to fixed rate payments and fixed rate
payment to floating rate payments.
Saving on the interest payment for borrowers arise because of arbitrage gains which are normally related to
differential risk spreads on the floating and fixed loan in a single market where the premiums associated
with fixed and floating debt are likely to differ because the markets have different characteristics.
Currency Swaps
These are similar to interest rate swaps but the underlying obligations are currencies. In currency swaps, the
currencies underlying swap are exchanged at the end of the swap and may be at the beginning of the swap.
When currencies are exchanged at the beginning and the end, same exchange rate is used. Putting in other
words, amount exchanged at the start and end of swap is the same. Interest payments by each party could
be fixed or floating.
With the standpoint of a financial manager or a treasurer, swap offer following benefits:
These provide access to greater markets where the companies have no direct approach. Particularly, large
size and high rated companies have access to money market but swaps provide small companies to access
this market.
It allows company to change an adverse fixed with favorable floating and vice versa.
Flexibility (not being standardized): swap can be arranged for any sum and period.
Comparatively low cost option
Off balance sheet transaction ­ shown as contingencies & commitments
However, there are some risks associated with swaps as well.
There may be some probability of default by either party before the swap expiry. This can be reduced by
transacting with bank or using financial institution as an intermediary.
There is a market risk as well. This represents the increase in the interest rates unfavorably after the
company has agreed to swap.
144
Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk