CHAPTER 16
SPECIAL FINANCING
VEHICLES
CHAPTER OVERVIEW
I.
II.
III.
IV.
V.
Interest Rate and Currency Swaps
Structured Notes
Interest Rate Forwards and
Futures
International Leasing
LDC Debt-Equity Swaps
I. Interest Rate and Currency
Swaps
I.
Interest Rate and Currency Swaps
A. Basic Features:
1. Explosive growth in swap
market
2. Two types of swaps:
- interest rate
Interest Rate Swaps
B. Interest Rate Swaps
1. Definition:
•
•
•
•
two-party agreement
to exchange interest payments
for a specific maturity
based on a notional principal
Interest Rate Swaps
2.Notional principal
Definition: the reference amount used to
calculate swap interest payments
Not the amount repaid by either
counterparty
Interest Rate Swaps
C.
1.
2.
3.
Swap Motivations
Risk-reducing potential
Cost savings
Exploit comparative advantages
enjoyed by different borrowers in
different financial markets
Interest Rate Swaps
D. Other Interest- Rate Swap Features:
1. No principal ever changes hands
2. Maturities:
1 - 15 years possible
2 - 10 years typical
Interest Rate Swaps
3.
Two Types of Interest-Rate Swaps
a. Coupon Swaps
• one counterparty pays a fixed rate
• second counterparty pays a floating rate
• floating rate resets periodically based on a
designated index
Interest Rate Swaps
3.
Two Types of Interest-Rate Swaps
(continued)
b. Basis swap
two counterparties exchange floating
interest payments based on the difference
in reference rates
Interest Rate Swaps
E.
The Classic Swap Transaction
- an example
1. Assumptions
Counterparty A: BBB-rated credit
Counterparty B: AAA-rated credit
Fixed-Rates Available
For A, 8.5% is best possible
For B, 7.0% is best possible
Interest Rate Swaps
1.
Assumptions (continued)
Floating Rates Available
For A
6-month LIBOR + 0.5%
For B
6-month LIBOR
Interest Rate Swaps
E.
The Classic Swap: Step-by-step
Step 1: A receives a $100 million
loan at LIBOR+50 points
from a syndicate of floatingrate lenders
(simultaneously)
B issues a $100 million
bond for 5 years fixed at 7%
THE CLASSIC SWAP (PART A)
STEP ONE:
COUNTERPARTY
B
COUNTERPARTY
A
Lend $100 million
5-year with resets
Floating-rate
Lenders
BOND
Issue
$100 million @7% MARKET
for 5 years
Interest Rate Swaps
Step 2: The Swap Agreement (Part A)
A borrows $100 million from
BigBank and agrees to pay
7.35% for 5 years (.0735 x $100 million)
THE CLASSIC SWAP (PART A)
STEP ONE:
COUNTERPARTY
A
Floating-rate
Lenders
$100 M
at 7.35%
BIGBANK
Lend $100 million
5-year with resets
Interest Rate Swaps
In exchange for depositing its
$100 million floating-rate loan
proceeds with BigBank, the
Bank agrees to pay
Counterparty A at the 6-month
LIBOR rate (resets to match the
original loan resets)
THE CLASSIC SWAP (PART A)
STEP ONE:
$100 M
at 7.35%
COUNTERPARTY
BIGBANK
A
Deposit
earns 6-mo
LIBOR
Floating-rate
Lenders
Lend $100 million
5-year with resets
Interest Rate Swaps
The results from Part A:
Counterparty A has effectively borrowed
at a fixed rate of 7.35% when otherwise
the best the could have received in the
fixed-rate market was 8.5%
Interest Rate Swaps
Step 2: The Swap Agreement (Part B)
B borrows from BigBank at the 6
month LIBOR floating rate for 5
years
In exchange for the deposit of
B’s bond proceeds of $100
million, BigBank agrees to pay B
at 7.25%
THE CLASSIC SWAP (PART B)
STEP TWO:
COUNTERPARTY
A
Floating-rate
Lenders
Borrow at LIBOR
BIGBANK
Deposit
at 7.25%
COUNTERPARTY
B
BOND
MARKET
Interest Rate Swaps
The Result from Part B:
Counterparty B has swapped a fixedrate loan for a floating-rate loan with an
effective cost of LIBOR - .25% when
otherwise the best the could have
obtained in the floating-rate market was
a LIBOR-only loan.
Interest Rate Swaps
Part C:
The Gains to BigBank from the
Swaps
BigBank:
Receives
7.35%
Pays
(7.25%)
Receives
LIBOR
Pays
(LIBOR)
Nets
.01%
Interest Rate Swaps
Part C:
The Gains to BigBank from the
Swap (continued)
BigBank receives
.001 x the notional principal
($100 million)
= $100,000 annually for 5 years
Interest Rate Swaps
F.Cost Savings
Counterparty Normal
A
8.5%
B
LIBOR
BigBank
Swap
7.85
L-.25
Total
Net
.65
.25
.10
1.00
Currency Swaps
G. Currency Swaps
1. Definition:
• an exchange of debt-service obligations
• denominated in one currency
• purpose:
for the service on an agreed upon principal
amount of debt denominated in another
Currency Swaps
2.
•
Motivation for Currency Swaps
a. Replaces parallel loan
b. Solve two potential problems:
1.) If no right of offset, default
by one party does not
release the other from
making payments.
Swaps have right of offset.
Currency Swaps
2).
Parallel loans remain on the
balance sheet whereas a
currency swap does not
Currency Swaps
3.
Difference between interest-rate and
Currency swaps:
a. Currency swaps have an
exchange of principal at
predetermined exchange
rates
Interest-Rate and Currency Swaps
H.
Economic Advantages of Swaps
1. Overcome barriers when they
exist to effective arbitrage such
as
• legal restrictions on forwards
• different perceptions by investors of the
•
creditworthiness of the two counterparties
tax differentials
Interest-Rate and Currency Swaps
H.
Economic Advantages of Swaps
(continued)
2.
They provide long-term
financing in foreign currencies
II. Structured Notes
II.
Structured Notes
A. Definition:
interest-bearing securities
whose interest payments are by
a formula set in advance
B. Formula
may be tied to a variety of
different often complex factors
Structured Notes
C.
Purpose of Structured Notes
1. They allow firms to speculate on
the direction, range, and
volatility of interest rates
2. They also can be used for
hedging purposes
Structured Notes
D. Types of Structured Notes
1. Inverse floaters
2. Step-ups
3. Step-downs
III. Interest Rate Forwards and
Futures
III.
Interest Rate Forwards and
Futures
A. Include:
1. Forward forwards
2. Forward rate agreements
3. Eurodollar futures
Interest Rate Forwards and
Futures
B.
Forward Forwards
1. Definition:
a contract that fixes an interest
rate today on a future loan or
deposit
2. Contract specifies
–interest rate
–principal amount
–start and ending dates of future
interest rate period
Interest Rate Forwards and
Futures
C.
Forward Rate Agreements
1. Definition:
a cash-settled, over-the-counter
forward contract that allows
–a fixed interest rate
– the rate to be applied in the future
on some notional principal amount
– the parties to exchange interest
payments
Interest Rate Forwards and
Futures
D.
Eurodollar Futures
1. Definition:
a cash-settled futures contract
on a three-month, $1 million
Eurodollar deposit that pays
LIBOR
2. Features are similar to currency
futures
IV. International Leasing
IV.
International Leasing
A. Purposes
1.
To defer and avoid taxes
2.
To safeguard firm’s foreign
subsidiary assets
3.
To avoid currency controls
International Leasing
B.
Types of Leases
1. Operating Lease (true lease)
• ownership and the use of the
asset are separated
• agreement covers only part of the
useful life of the asset
International Leasing
B.
Types of Leases
2. Financial lease
• extends over most of the economic life
of the asset
• noncancelable
• if cancelable, it requires substantial
penalty to the lessor
• in effect, lessor borrows money and
then purchases the asset
International Leasing
3.
Tax Factors
a lease that qualifies as a true lease
for tax purposes is called a taxoriented lease entitling lessee to
deduct full value of lease payments
International Leasing
if a financial lease, lessee allowed
• tax depreciation for the purchase price
• tax deduction for the interest factor
• lessor not entitled to tax benefits
V. LDC Debt-Equity Swaps
V. LDC Debt-Equity Swaps
A. The LDC Debt-Equity Market
1. enables investors to purchase
the external debt of lessdeveloped countries (LDC) to
acquire equity or domestic
currency in those same markets
LDC Debt-Equity Swaps
B.
Types of Debt Swaps and Rationale
1. LDC loans sell at deep discounts
to their face value
2. Substantial variation can occur
across countries
LDC Debt-Equity Swaps
3.
4.
Investors buy loans in
expectation that credit ratings
will increase
Arbitrage opportunities occur.
The market offers a more
favorable exchange rate that do
official currency markets.
LDC Debt-Equity Swaps
C.
Costs and Benefits of Debt Swaps
1.
Debt swaps and inflation
2.
Impact on capital Formation
3.
Effect on privatization