SPECIAL FINANCING VEHICLES

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CHAPTER 16

• SPECIAL FINANCING VEHICLES

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CHAPTER OVERVIEW

• I. Interest Rate and Currency Swaps
• II. Structured Notes
• III. Interest Rate Forwards and Futures
• IV. International Leasing
• V. LDC Debt-Equity Swaps

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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

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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

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Interest Rate Swaps

• 2. Notional principal
• Definition the reference amount used to
  calculate swap interest payments
• Not the amount repaid by either counterparty

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Interest Rate Swaps

• C. Swap Motivations
• 1. Risk-reducing potential
• 2. Cost savings
• 3. Exploit comparative advantages enjoyed by
  different borrowers in different financial
  markets

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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

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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

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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

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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

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Interest Rate Swaps

• 1. Assumptions (continued)
• Floating Rates Available
• For A 6-month LIBOR 0.5
• For B 6-month LIBOR

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Interest Rate Swaps

• E. The Classic Swap Step-by-step
• Step 1 A receives a 100 million loan at
  LIBOR50 points
• from a syndicate of floating-
• rate lenders (simultaneously)
• B issues a 100 million bond for 5 years
  fixed at 7

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THE CLASSIC SWAP (PART A)

• STEP ONE

COUNTERPARTY B
COUNTERPARTY A
Lend 100 million 5-year with resets
Floating-rate Lenders
BOND MARKET
Issue 100 million _at_7 for 5 years
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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)

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THE CLASSIC SWAP (PART A)

• STEP ONE

100 M at 7.35
BIGBANK
COUNTERPARTY A
Floating-rate Lenders
Lend 100 million 5-year with resets
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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)

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THE CLASSIC SWAP (PART A)

• STEP ONE

100 M at 7.35
BIGBANK
COUNTERPARTY A
Deposit earns 6-mo LIBOR
Floating-rate Lenders
Lend 100 million 5-year with resets
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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

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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 Bs bond
  proceeds of 100 million, BigBank agrees to
  pay B at 7.25

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THE CLASSIC SWAP (PART B)

• STEP TWO

Borrow at LIBOR
BIGBANK
COUNTERPARTY A
COUNTERPARTY B
Floating-rate Lenders
BOND MARKET
Deposit at 7.25
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Interest Rate Swaps

• The Result from Part B
• Counterparty B has swapped a fixed-rate 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.

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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

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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

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Interest Rate Swaps

• F. Cost Savings
• Counterparty Normal Swap Net
• A 8.5 7.85 .65
• B LIBOR L-.25 .25
• BigBank .10
• Total 1.00

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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

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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.

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Currency Swaps

• 2). Parallel loans remain on the balance
  sheet whereas a currency swap does not

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Currency Swaps

• 3. Difference between interest-rate and
• Currency swaps
• a. Currency swaps have an exchange of
  principal at predetermined exchange rates

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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

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Interest-Rate and Currency Swaps

• H. Economic Advantages of Swaps (continued)
• 2. They provide long-term financing in
  foreign currencies

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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

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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

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Structured Notes

• D. Types of Structured Notes
• 1. Inverse floaters
• 2. Step-ups
• 3. Step-downs

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III. Interest Rate Forwards and Futures

• III. Interest Rate Forwards and Futures
• A. Include
• 1. Forward forwards
• 2. Forward rate agreements
• 3. Eurodollar futures

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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

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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

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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

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IV. International Leasing

• IV. International Leasing
• A. Purposes
• 1. To defer and avoid taxes
• 2. To safeguard firms foreign subsidiary
  assets
• 3. To avoid currency controls

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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

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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

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if a financial lease, lessee allowed tax
depreciation for the purchase price tax
deduction for the interest factorlessor not
entitled to tax benefits International Leasing

• 3. Tax Factors
• a lease that qualifies as a true lease for tax
  purposes is called a tax- oriented lease
  entitling lessee to
• deduct full value of lease payments

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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

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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 less- developed countries (LDC) to
• acquire equity or domestic
• currency in those same markets

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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

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LDC Debt-Equity Swaps

• 3. Investors buy loans in expectation that
  credit ratings will increase
• 4. Arbitrage opportunities occur. The market
  offers a more favorable exchange rate that do
  official currency markets.

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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