Derivatives Trading Desk

TRADING - TREASURY

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

1. Interest Rate Swap (IRS)
 Exchanging payments on regular future dates for a defined period of time
 2 payment legs on different basis; fixed/float
 Floating rate based on LIBOR or any variable rate
 Plain vanilla IRS characteristics:
 Notional principal is fixed at outset and never varies
 Notional is never exchanged; it’s used for payments calculations
 One party agrees to pay fixed rate
 Other party agrees to make return payment based on variable rate
 When floating payment is made, Libor rate is reset for next floating payment

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

1. Interest Rate Swap (IRS)
A pays fixed to B ; A receives float from B
Notional Principal GBP 100 million
Fixed payer A pays fixed at 5% p.a
Floating payer B pays 12-mo Libor p.a
Payments (both legs) Annually in arrears
Start date Today
Maturity 10 years
First LIBOR fix 3,75%

5% pa
A B
Libor

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

1. Interest Rate Swap
To give clearer example, suppose A owe a loan to a bank :
 GBP 100 million
10 yrs tenor
Rate of interest is reset every year according to 12-mo sterling LIBOR + spread (0,75%)

5% pa
A B
Libor+spread

Bank Loan

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

1. Interest Rate Swap (IRS)
 A is exposed to rising interest rate
 A approaches B for swap dealing
 After one year, LIBOR rate is 6%, A must pay 6,75% or GBP 6,75 mio to the bank
 A pays 5% (5 mio) to B; A receives 6% (GBP 6 mio) from B for the swap deal
 Net borrowing cost of A = 6,75%+5%-6% = 5,75% p.a on GBP 100 mio
 Simulation (in mio £):
LIBOR Bank Loan Loan Interest Swap fixed pay Swap float rec net
4% 4,75% -4,75 -5,00 4,00 -5,75
5% 5,75% -5,75 -5,00 5,00 -5,75
6% 6,75% -6,75 -5,00 6,00 -5,75
7% 7,75% -7,75 -5,00 7,00 -5,75

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

2. Dollar IRS
 ABC Corporation and Notional Principal $ 100 million
a Bank; $ 100 mio Counterparty ABC Corporation
 Bank receives fixed Bank receives fixed at 4,75% pa paid annually
and pays float Bank pays float at 6-mo USD Libor, paid every 6-mo, reset
 Swap starts on spot every 6-mo
date, T+2 Day-count for both legs Actual/360
 Payments made Trade date 31-July-2003
every 6 months, Start date 4-Aug-2003
starting spot
Maturity date 4-Aug-2013
First Libor setting 1,13875% p.a

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

2. Dollar IRS
Float payment

Bank ABC Corporation

Fixed payment
At first swap payment (4 Feb 2004 – 184 actual days from 4 Aug 2003)
Floating payment made = -$100 mio x 1,13875% x (184/360) = -$0,582 mio
At second swap payment (4 Aug 2004 – 182 days from 4 Feb 2004)
Libor reset to 2% - market determined
Floating payment made = -$100 mio x 2% x (182/360) = -$1,0111 mio
At 4 Aug 2004, bank received fixed payment (period: 4 Aug 2003-4 Aug 2004)
Fixed payment received = $100 mio x 4,75% x 366/360 = $4,83 mio

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

3. Cross Currency Swap (CCS)
 Exchanging cash flows from one currency to other
 Principal amounts are normally exchanged at spot foreign exchange rate at the start of the
swap and then re-exchanged at same rate on final payment date
 Interest payment can be calculated on a fixed or floating basis
 Example:
Americo Corp (American, access to USD) Britco Corp (British, access to Pounds)
S&P : A S&P: BB+
Wants to borrow £100 mio Wants to borrow $150 mio
Fixed borrowing rate in $ : 5% Fixed borrowing rate in $ : 6,50%
Fixed borrowing rate in £ : 6% Fixed borrowing rate in £ : 6,75%
Rate : USDGBP 1,5

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

3. Cross Currency Swap (CCS)
Dealer comes in :
Swap with Americo
 Dealer takes $150 mio from Americo, gives £100 mio. Principals will be exchanged at same FX rate
in next 10 yrs.
Dealer agrees to pay Americo 5% on $150 mio (utilising its credit facilities in USA); receive (Americo
pays) 5,75% on £100 mio which is better than market
Swap with Britco
 Swap dealer takes £100 mio from Britco (utilising its credit facilities in UK), gives $150 mio.
Principals will be re-exchanged at same FX rate on swap payment date
 Dealer agrees to pay Britco 6,75% on £100 mio for next 10 yrs; Britco pays 6,35% on $150 mio which
is better than its rate.

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

3. Cross Currency Swap (CCS)
$ 150 mio $ 150 mio

Americo Swap Dealer Britco

£ 100 mio £ 100 mio

$ 150 mio £ 100 mio

LOAN in USD LOAN in GBP

Principal Swap
(start)

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

3. Cross Currency Swap (CCS)
£5,75 mio (5,75% on £ 100 mio) £6,75 mio (6,75% on £100 mio)

Americo Swap Dealer Britco

$7,5 mio $9,525 mio
(5% on $150 mio) (6,35% on $150 mio)

$ 7,5 mio (5% on $150 mio) £6,75 mio (6,75% on £ 100 mio)

LOAN in USD LOAN in GBP

Interest payment

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

3. Cross Currency Swap (CCS)
$ 150 mio $ 150 mio

Americo Swap Dealer Britco

£ 100 mio £ 100 mio

$ 150 mio £ 100 mio

LOAN in USD LOAN in GBP

Principal Swap
(maturity)

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

3. Cross Currency Swap (CCS)
 Dealer receives and pays over the principal amounts to the two other parties.
So net effect is zero.
 Each year the dealer receives 6,35% and pays 5% on $150 mio.
Resulting positive cash flow of $2,025 mio per annum.
 Each year the dealer pays 6,75% and receives 5,75% on £100 mio.
Resulting negative cash flow of £1 mio per annum.
 Dealer should manage the currency rate risk between the two cash flow.
 Dealer should find parties that have substantial credit rating difference (wide spread on
interest between the two).

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

3. Cross Currency Swap (CCS)
The opportunity for the dealer is when the greater CF currency strengthens
In this case cash inflows in USD is greater than cash outflows in GBP, so opportunity comes when
USD strengthens.
Rate CF1 (USD) CF2 (GBP) - £1mio P&L for dealers
1,1 $2,025 mio -$1,1 mio $0,925
1,3 $2,025 mio -$1,3 mio $0,725
1,5 USD/GBP $2,025 mio -$1,5 mio $0,525
1,7 $2,025 mio -$1,7 mio $0,325
1,9 $2,025 mio -$1,9 mio $0,125
2,1 $2,025 mio -$2,1 mio -$0,075
2,3 $2,025 mio -$2,3 mio -$0,275
2,5 $2,025 mio -$2,5 mio -$0,475

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)

Thank you

TRIZAR RIZQIAWAN - TAKEN FROM CHISHOLM (2004)