Multinational corporations can use creative financing to achieve various objectives, such as lowering their cost of...

    

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Multinational corporations can use creative financing to achieve various objectives, such as lowering their cost of funds, cutting taxes, and reducing political risk. This chapter focused on two such techniques-interest rate and currency swaps and interest rate forward and futures contracts. Interest and currency swaps involve a financial transaction in which two counterparties agree to exchange streams of payments over time. In an interest rate swap, no actual principal is exchanged either initially or at maturity, but interest payment streams are exchanged according to predetermined rules and are based on an underlying notional amount. The two main types are coupon swaps (or fixed rate to floating rate) and basis swaps (from floating rate against one reference rate to floating rate with another reference rate). Currency swap refers to a transaction in which two counterparties exchange specific amounts of two currencies at the outset and repay over time according to a predetermined rule that reflects both interest payments and amortization of principal. A cross-currency interest rate swap involves swapping fixed-rate flows in one currency to floating-rate flows in another. Interest forward and futures contracts enable companies to manage their interest rate expense and risk. These contracts include forward forwards, forward rate agreements, and Eurodollar futures. All of them allow companies to lock in interest rates on future loans and deposits. A forward forward is a contract that fixes an interest rate today on a future loan or deposit. The contract specifies the interest rate, the principal amount of the future deposit or loan, and the start and ending dates of the future interest rate period. A forward rate agreement is a cash-settled, over-the-counter forward contract that allows a company to fix an interest rate to be applied to a specified future interest period on a notional principal amount. Eurodollar futures, which are based on a three-month, $1 million Eurodollar deposit that pays LIBOR, act like FRAS in that they help lock in a future interest rate and are settled in cash. However, unlike FRAs, they are marked to market daily. Eurodollar futures contracts are traded on several U.S. and overseas exchanges. Structured notes are complex debt instruments whose payments are tied to a reference index, such as LIBOR, and have one or more embedded derivative elements, such as swaps, forwards, or options. However, they do perform a valuable function. They allow corporations and financial institutions to function more efficiently by enabling them to tailor financial products to meet their individual needs. Finally, credit default swaps allow for the transfer of credit risk from one party to another. They function like insurance against a bond default or other negative credit event. The CDS seller assumes the credit risk on the debt in exchange for a periodic protection fee from the buyer similar to an insurance premium. If a credit event occurs, the CDS holder is paid by the seller of the protection. QUESTIONS 8.1 What is an interest rate swap? What is the difference between a basis swap and a coupon swap? 8.2 What is a currency swap? 8.3 Comment on the following statement. "In order for one party to a swap to benefit, the other party must lose." 8.4 The Swiss Central Bank bans the use of Swiss francs for Eurobond issues. Explain how currency swaps can be used to enable foreign borrowers who want to raise Swiss francs through a bond issue outside of Switzerland to get around this ban. 8.5 Explain how IBM can use a forward rate agreement to lock in the cost of a one-year $25 million loan to be taken out in six months. Alternatively, explain how IBM can lock in the interest rate on this loan by using Eurodollar futures contracts. What is the major difference between using the FRA and the futures contract to hedge IBM's interest rate risk? 8.6 In "The Big Short: Inside the Doomsday Machine" Michael Lewis writes "a credit default swap was confusing mainly because it wasn't really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term." In what way is a CDS a swap? In what way is a CDS different from an interest rate swap? Multinational corporations can use creative financing to achieve various objectives, such as lowering their cost of funds, cutting taxes, and reducing political risk. This chapter focused on two such techniques-interest rate and currency swaps and interest rate forward and futures contracts. Interest and currency swaps involve a financial transaction in which two counterparties agree to exchange streams of payments over time. In an interest rate swap, no actual principal is exchanged either initially or at maturity, but interest payment streams are exchanged according to predetermined rules and are based on an underlying notional amount. The two main types are coupon swaps (or fixed rate to floating rate) and basis swaps (from floating rate against one reference rate to floating rate with another reference rate). Currency swap refers to a transaction in which two counterparties exchange specific amounts of two currencies at the outset and repay over time according to a predetermined rule that reflects both interest payments and amortization of principal. A cross-currency interest rate swap involves swapping fixed-rate flows in one currency to floating-rate flows in another. Interest forward and futures contracts enable companies to manage their interest rate expense and risk. These contracts include forward forwards, forward rate agreements, and Eurodollar futures. All of them allow companies to lock in interest rates on future loans and deposits. A forward forward is a contract that fixes an interest rate today on a future loan or deposit. The contract specifies the interest rate, the principal amount of the future deposit or loan, and the start and ending dates of the future interest rate period. A forward rate agreement is a cash-settled, over-the-counter forward contract that allows a company to fix an interest rate to be applied to a specified future interest period on a notional principal amount. Eurodollar futures, which are based on a three-month, $1 million Eurodollar deposit that pays LIBOR, act like FRAS in that they help lock in a future interest rate and are settled in cash. However, unlike FRAs, they are marked to market daily. Eurodollar futures contracts are traded on several U.S. and overseas exchanges. Structured notes are complex debt instruments whose payments are tied to a reference index, such as LIBOR, and have one or more embedded derivative elements, such as swaps, forwards, or options. However, they do perform a valuable function. They allow corporations and financial institutions to function more efficiently by enabling them to tailor financial products to meet their individual needs. Finally, credit default swaps allow for the transfer of credit risk from one party to another. They function like insurance against a bond default or other negative credit event. The CDS seller assumes the credit risk on the debt in exchange for a periodic protection fee from the buyer similar to an insurance premium. If a credit event occurs, the CDS holder is paid by the seller of the protection. QUESTIONS 8.1 What is an interest rate swap? What is the difference between a basis swap and a coupon swap? 8.2 What is a currency swap? 8.3 Comment on the following statement. "In order for one party to a swap to benefit, the other party must lose." 8.4 The Swiss Central Bank bans the use of Swiss francs for Eurobond issues. Explain how currency swaps can be used to enable foreign borrowers who want to raise Swiss francs through a bond issue outside of Switzerland to get around this ban. 8.5 Explain how IBM can use a forward rate agreement to lock in the cost of a one-year $25 million loan to be taken out in six months. Alternatively, explain how IBM can lock in the interest rate on this loan by using Eurodollar futures contracts. What is the major difference between using the FRA and the futures contract to hedge IBM's interest rate risk? 8.6 In "The Big Short: Inside the Doomsday Machine" Michael Lewis writes "a credit default swap was confusing mainly because it wasn't really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term." In what way is a CDS a swap? In what way is a CDS different from an interest rate swap?

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QUEST IONS 8 1 What is an interest rate swap ANS WER An interest rate swap is a financial transaction in which two counterpart ies agree to exchange streams of payments over time In an interest rate s... View the full answer