Copyright 1999 A.S. Cebenoyan 1

C15.0021 Money, Banking, and Financial Markets

Professor A. Sinan Cebenoyan

NYU-Stern-Finance

Copyright 1999 A.S. Cebenoyan 2

Interest-Rate Swap Example(borrowed from Katerina Simons, New England Economic Review, 1989)

• 3 Parties involved:– A Public Utility (BBB rated)

– A Finance Company (AAA rated)

– A Bank (AA rated)

• Starting Positions:– Utility: has low credit rating. Wants to match its LT

assets with LT fixed-rate debt. But finds it expensive

– Finance Co: has good rating. Can obtain low cost fixed rate debt, but prefers ST or floating to match ST assets.

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•Bank serves as middleman

•Borrowing costs before swap (%):

Fixed Rate Floating Rate

Public Utility 10.00 LIBOR + .80

Finance Co. 8.85 LIBOR + .30

difference 1.15 .50

•The finance co. enjoys a lower borrowing cost in both markets.

•But, the public utility faces relatively lower costs in floating rate mkt. It has a comparative advantage of 65 bp (115 - 50). This 65 bp comp. Advantage is the amount of potential savings from the swap.

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Public

Utility (BBB)

Bank

(AA)

Finance Company

(AAA)

Pays 9% fixed

Pays 8.9% fixd

LIBORLIBOR

Borrows floating

LIBOR + .80

Borrows fixed

8.85 %

Public Utility pays bank fixed 9% and receives LIBOR. Its Total Borrowing costs are:

9% - LIBOR + ( LIBOR + .80 ) = 9.8%

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Finance Company pays Bank LIBOR and receives 8.9% fixed. Its Total borrowing costs are:

LIBOR - 8.9% + 8.85% = LIBOR - 0.05%

In Summary:

Public Utility Finance Company

Pays 9% Pays LIBOR

-Receives LIBOR -Receives 8.9%

Borrows LIBOR + .80 Borrows 8.85%

9.8% LIBOR - .05%

Cost w/o swap 10.0% LIBOR + .30%

SAVINGS .20 % .35%

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Total Potential savings from swap were .65%.

The bank takes .10 % spread as compensation for the swap.

•Note:

•The parties have not exchanged obligations to make principal payments, only to make each other’s interest payments.

•Hedges may not be perfect

•This is a simple example to display the mechanics of a swap. It does not go into risks, and exposures to the parties involved.

•Interest rate movements and credit risks are very important.