hedging financial market exposure interest rate swaps cross currency interest rate swaps
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Hedging Financial Market Exposure
Interest Rate SwapsCross Currency Interest Rate Swaps
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What is a Derivative??
“A contract or security, whose value is derived from the price or level changes in some other underlying security, index or other instrument.”- Wall Street Journal definition.
A separate financial contract which alters one’s exposure to future changes in: interest rates, equity security prices, commodity prices or foreign exchange rates.
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Interest Rate Swaps
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Interest Rate Swaps
Floating Rates of Interest:
PRIME: “The base rate on corporate loans posted by at least 75% of the nations 30 largest banks.” The PRIME rate is subject to change on a daily basis.
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Interest Rate Swaps
Floating Rates of Interest:
LIBOR: (London Interbank Offered Rate) “British Bankers Association average of interbank offered rates for dollar deposits in the London market based on quotations at 16 major banks.” The LIBOR rate is available for 1, 2, 3, 4, 5, 6 and 12 month maturity’s.
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Interest Rate Swaps
Historical Prime and Libor rates
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
3/1/90
3/1/92
3/1/94
3/1/96
3/1/98
3/1/00
3/1/02
Prime
LIBOR
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Interest Rate Swaps
Historical yield on 5 Year Treasury Note
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
3/1/90 3/1/92 3/1/94 3/1/96 3/1/98 3/1/00 3/1/02
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Interest Rate Swaps
Forward Interest Rate Curve on LIBOR
3.00%
4.00%
5.00%
6.00%
7.00%
9/1/01 9/1/02 9/1/03 9/1/04 9/1/05 9/1/06
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Interest Rate Swaps
ABC
PNC Bank
Libor + 2.00%
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Interest Rate Swaps
PNC Capital Markets
ABC
PNC Bank
Libor + 2.00%
Libor
Swap Rate: 5.50%
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Interest Rate Swaps
Swap Details:
Notional Amount: $1,000,000Start Date: August 7, 2001Maturity Date: August 7, 2006Amortization: $0 (bullet amortization)ABC Pays: 5.50% Swap Rate, Quarterly, Actual/360ABC Receives: Libor, Quarterly, Actual/360
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Interest Rate Swaps
Interest Rate Swap Mechanics
Floating Rate LoanABC Pays LIBOR 3.75% 5.75% 1.75%ABC Pays Spread 2.00% 2.00% 2.00%Loan Interest 5.75% $14,375 7.75% $19,375 3.75% $9,375
Interest Rate SwapABC Receives LIBOR -3.75% -5.75% -1.75%ABC Pays Swap Rate 5.50% 5.50% 5.50%Swap Payment (Receipt) 1.75% $4,375 -0.25% ($625) 3.75% $9,375
All-In Rate 7.50% $18,750 7.50% $18,750 7.50% $18,750
Current What if Rates Rise What if Rates Fall
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ABC
Bondholder
Fixed Coupon:7.25%
Interest Rate Swaps
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PNC Capital Markets
ABC
Bondholder
Fixed Coupon:7.25%
Libor + 1.75%
Swap Rate: 7.25%
Interest Rate Swaps
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• Assess bank market versus corporate bond market/private placement market.
• Issue debt in the market which has a “comparative advantage” in terms of spreads, covenants, etc.
• Use Swaps and/or Reverse Swaps to implement the Fixed
versus Floating strategy.
Interest Rate Swaps
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Cross Currency Interest Rate Swaps
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Cross Currency Interest Rate Swaps
• ABC has an opportunity to make a direct investment in Europe, utilizing EURO as the currency.
• The “Investment” may consist of hard assets (real estate/equipment) or an operating company.
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Cross Currency Interest Rate SwapsABC EuroEURO Investment
Principal CashflowsInterest Cashflows
Bank of Euro
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Cross Currency Interest Rate Swaps
• Unfortunately for ABC, it is unable to raise EURO denominated financing from a European bank.
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Cross Currency Interest Rate Swaps
Principal CashflowsInterest Cashflows
Loan
Request
ABC EuroEURO Investment
Bank of Euro
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Cross Currency Interest Rate Swaps
• Fortunately for ABC, it does have a strong relationship with a domestic bank that is experienced in delivering international financing solutions.
• ABC will raise USD financing.
• ABC will then enter into a Cross Currency Interest Rate Swap.
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Cross Currency Interest Rate Swaps
• The Cross Currency Swap has these primary features:
– Converts USD into EURO. Utilize EURO to make investment.
– No foreign exchange risk, as EURO investment cash flows are converted to USD for debt service (P&I) based on a pre-determined, fixed exchange rate.
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Cross Currency Interest Rate Swaps
Principal CashflowsInterest Cashflows
ABC EuroEURO Investment
PNC Capital Markets
PNC Bank
ABC
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Cross Currency Interest Rate Swaps
Principal CashflowsInterest Cashflows
ABC EuroEURO Investment
PNC Capital Markets
PNC Bank
USD Principal
ABC
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Cross Currency Interest Rate Swaps
Principal CashflowsInterest Cashflows
ABC EuroEURO Investment
PNC Capital Markets
PNC Bank
USD Principal
USD Principal Exchange
EURO Principal Exchange
ABC
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Cross Currency Interest Rate Swaps
Principal CashflowsInterest Cashflows
ABC EuroEURO Investment
EURO Principal
PNC Capital Markets
PNC Bank
USD Principal
USD Principal Exchange
EURO Principal Exchange
ABC
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Cross Currency Interest Rate SwapsABC EuroEURO Investment
EURO Principal
PNC Capital Markets
PNC Bank
USD Principal
Libor
EURO Principal Exchange
Libor
EURO Swap Rate
Principal CashflowsInterest Cashflows
ABC
EURO Fixed Rate
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Cross Currency Interest Rate SwapsABC EuroEURO Investment
EURO Principal
PNC Capital Markets
PNC Bank
USD Principal
USD Libor
USD Principal Exchange
EURO Principal Exchange
USD Libor
EURO Swap Rate
Principal CashflowsInterest Cashflows
EURO Fixed Rate
ABC
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Cross Currency Interest Rate SwapsABC EuroEURO Investment
EURO Principal
EURO Fixed Rate
PNC Capital Markets
PNC Bank
USD Principal
USD Libor
USD Principal Exchange
EURO Principal Exchange
USD Libor
EURO Swap Rate
Principal CashflowsInterest Cashflows
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12
3
44
5
67
8
9
10
11
ABC
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Cross Currency Interest Rate SwapsInitial principal advances and use of proceeds:1) PNC Bank lends USD to ABC.2) ABC delivers USD to PNC Capital Markets.3) PNC Capital Markets delivers EURO to ABC.4) ABC lends EURO to ABC Euro.
Debt Service Payments:5) ABC Euro pays EURO interest to ABC.6) ABC pays EURO Swap Rate to PNC Capital Markets.7) PNC Capital Markets pays USD Libor to ABC.8) ABC pays USD Libor to PNC Bank.
Payoff Loan & Terminate Swap:9) ABC retires its EURO Loan from ABC.10) ABC delivers EURO to PNC Capital Markets.11) PNC delivers USD to ABC.12) ABC retires USD loan from PNC Bank.
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Hedging Financial Market Exposure
The data contained herein is based upon information obtained from sources believed to be reliable, but since it has not been independently verified, such data is not guaranteed as to accuracy or completeness. All pricing is indicative and subject to firm quotes. The above is intended for informational purposes only and should not be construed as trading advice or recommendations to buy or sell currencies or securities or to engage in any other transaction. Swap, collar and FRA transactions are subject to PNC Bank credit approval.
Clients should evaluate the financial, market, legal, regulatory, credit, tax and accounting risks and consequences of the any and all transactions proposed before entering into or purchasing any instrument, involving a financial derivative. Clients should undertake their own evaluation of the risks and consequences of a transaction independently of PNC Bank. PNC Bank assumes no liability for any errors or omissions in this presentation.
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