IX: Market Innovations
28: Interest Rate Agreements
Interest Rate Agreements
 Ceiling
 The buyer pays a premium and in return is
compensated if the interest rate rises above
the ceiling.
 Floor
 The buyer pays a premium and in return is
compensated if the interest rate falls below the
floor.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Ceiling
 Cemex Inc buys a ceiling from the Citibank




The reference rate is LIBOR
The ceiling is set at 6%
The notional principal amount is $10m
The agreement calls for quarterly settlement
for 1 year.
 The agreement is signed January 1, 2007
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Ceiling
Date
LIBOR
Payment to Cemex
April 1, 2007
5.9%
July 1, 2007
6.1%
0.1% x $10m
4
$2,500.
October 1, 2007
6.8%
0.8% x $10m
4
$20,000.
January 1, 2008
5.8%
Chapter 27: Swap Agreements
$0.
$0.
© Oltheten & Waspi 2012
Ceiling
7.0%
6.80%
$20,000
6.5%
6.10%
$2,500
6.0%
Ceiling
5.9%
$0
5.5%
5.80%
$0
5.0%
1 Jan 07
Chapter 27: Swap Agreements
1 Apr 07
1 Jul 07
1 Oct 07
1 Jan 08
© Oltheten & Waspi 2012
Floor
7.0%
6.80%
$0
6.5%
6.10%
$0
6.0%
Floor
5.9%
$2,500
5.5%
5.80%
$5,000
5.0%
1 Jan 07
Chapter 27: Swap Agreements
1 Apr 07
1 Jul 07
1 Oct 07
1 Jan 08
© Oltheten & Waspi 2012
IX: Market Innovations
Credit Default Swaps
Total Return Swap
 Separates Interest rate Risk from Credit Risk
 Funding Leg = variable
 Return Leg = fixed interest plus unrealized gain
or loss
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Total Return Swap
 JQ Investor
 $100,000 6% Discovery Café @ 100
 Total Return Swap
 Speculative Hedge Fund @ LIBOR +0.5%
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Total Return Swap
 Risk:
 Interest Rate: LIBOR = 5.5%
 Credit: Discovery Café @100
 Swap
Funding Leg:
Return Leg:
Chapter 27: Swap Agreements
5.5% + 0.5%:
6%:
Unrealized gain:
Net Swap Payment:
+ $3,000
- $3,000
$0
$0
© Oltheten & Waspi 2012
Total Return Swap
 Risk:
 Interest Rate: LIBOR = 5.2%
 Credit: Discovery Café @102
JQ pays his
gain to the
Hedge Fund
 Swap
Funding Leg:
Return Leg:
Chapter 27: Swap Agreements
5.2% + 0.5%:
6%:
Unrealized gain:
Net Swap Payment:
+ $2,850
- $3,000
- $2,000
- $2,150
© Oltheten & Waspi 2012
Total Return Swap
 Risk:
 Interest Rate: LIBOR = 5.0%
 Credit: Discovery Café @46
Yields down,
bond prices
should go up
but Discovery
Café Bond
reflects credit
risk
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Total Return Swap
 Risk:
 Interest Rate: LIBOR = 5.0%
 Credit: Discovery Café @46
Hedge Fund takes
on credit risk; JQ is
compensated
 Swap
Funding Leg:
Return Leg:
Chapter 27: Swap Agreements
5.0% + 0.5%:
6%:
Unrealized gain:
Net Swap Payment:
+ $2,750
- $3,000
- - $55,000
+ $54,750
© Oltheten & Waspi 2012
Credit Default Swap
 JQ Investor
 $100,000 6% Discovery Café @ 100
 Credit Default Swap
 Speculative Hedge Fund CDS @1%
 0.25% ($250)paid to SHF quarterly
 Unlike the Total Return Swap SHF pays JQ only
upon default.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
IX: Market Innovations
Pollution Allocation Units
Natural Resource Economics
 In production factors of production are
used to the point where
marginal cost = marginal revenue
 Economic Allocation Rights add the cost of
open access natural resources back into the
production function.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Pollution Rights
 Sulphur Dioxide Emission Unit allows the
emission of 1 ton of SO2 up to the
expiration year.
 1 ton SO2 emitted in 2009 must be paid for
with a 2009 SO2 unit or a banked pre-2009 unit
 In March of 2010 the EPA issues units based on
historical emissions and auctions 2010 and
2017 units
http://www.evomarkets.com/
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Pollution Rights
 The old factory can reduce emissions by
6
spending
 $500 1st ton
 $600 2nd ton
 $700 3rd & 4th ton
tons
 The new factory can reduce emissions by
6
spending
tons
 $200 1st & 2nd ton
 $300 3rd & 4th ton
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Pollution Rights
 Congress mandates a reduction of 2 tons by
each factory.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Cost of reducing emissions
4
tons
 The old factory
 $500 1st ton
$1,100
 $600 2nd ton
 $700 3rd & 4th ton
 The new factory
$400
 $200
ton
 $300 3rd & 4th ton
1st & 2nd
TOTAL COST:
Chapter 27: Swap Agreements
4
tons
$1,500
© Oltheten & Waspi 2012
Cost of reducing emissions
6
tons
 The old factory
 $500 1st ton
 $600 2nd ton
 $700 3rd ton
Buy 2 extra pollution
credits for $400 each
 The new factory
 $200 1st & 2nd ton
 $300 3rd & 4th ton
TOTAL COST:
Chapter 27: Swap Agreements
Sell 2 extra pollution
credits for $400 each
$1,000
2
tons
© Oltheten & Waspi 2012
Cost of reducing emissions
 The old factory
 $500 1st ton
 $600 2nd ton
 $700 3rd ton
 The new factory
 $200 1st & 2nd ton
 $300 3rd & 4th ton
TOTAL COST:
Chapter 27: Swap Agreements
Cost of credits $800 < $1,100
$1,000 +$800=$200
$200 < $400
$1,000 < $1,500
© Oltheten & Waspi 2012
Drop Options
Drop Options
 Each student entering the College of
Business will receive two Drop Options.
DROP OPTION
Entitles the student to drop one 3 hour
course at any time, up to an including the
last day of class, without penalty.
Assumes four years
to graduation plus
one year buffer zone
Expires: May 15, 2014
Registered to: John Q. Student
Can be used by John
Q. Student or sold to
another student.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Drop Options
 Drop Options will trade in the open market.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Drop Options
 Joe is a well-motivated
student who plans his
program of study and
follows it. He never uses
his drop options.
 In his final semester he
sells his drop options for
$300 each.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Drop Options
 Susan drops Marketing 306 but sells her
other drop option in her
senior year
for $320.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
Drop Options
 Sterling Silverspoon III is drops two classes
in his freshman year.
 He needs two more drop options to repeat
Finance 300 (twice). He pays $300 for the
first and $320 for the second.
 He drops Corporate Finance once ($320)
and Futures and Options once ($330).
 He drops Financial Engineering once ($300)
and decides to take Investments instead.
Chapter 27: Swap Agreements
© Oltheten & Waspi 2012
The End