Citibank: basic of corporate finance
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Banks as
intermediaries
In the example, we said that LDM and XYZ arranged the swap through
an intermediary. Most companies lack the resources and expertise to
find suitable counterparties and evaluate their credit-worthiness. A
large, money-center bank will act as an intermediary in most swap
transactions. The bank serves as a clearinghouse for the interest
payments and guarantees performance by each counterparty.
From the company's perspective, the swap is essentially made with
the bank — it may not know or even care who the counterparty is.
Of course, the bank charges a fee for providing these services,
usually in the form of a few basis points added to the overall rate that
is paid in the swap. The bank usually receives a fee from both
counterparties, so the all-in-cost of the interest payments for each
company will include the fees paid to the bank.
Currency Swaps
Exchange of
cash flows in
different
currencies
A currency swap is an exchange of cash flows denominated in one
currency for the cash flows in a different currency. The driving force
behind the swap might be that a company may be able to borrow in one
currency at a lower rate than in another currency. Let's look at
an illustration that shows how a currency swap might work.
Example
Consider a German company and a U.S. corporation that are trying to
raise financing for their respective businesses in their home
currencies. The German company has borrowed in the Deutsche mark
(DM) bond market extensively in the past few months. This means that
there could be a relative overabundance of DM-denominated debt
issued by German companies and investors' demand is low. However,
there is relatively little DM-denominated debt issued by U.S.
corporations in that market. This situation may mean that a U.S.
company could issue bonds at a lower rate than the German firm in the
DM market.
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In the US$ market, investors perceive that the German company is a
better credit risk than the U.S. corporation, and the German
company could issue bonds at a lower rate in the US$ market. This is
an opportunity for a swap to occur between the two companies. The
German company could issue in the US$ market and the U.S.
corporation could issue in the DM market. The two companies
would exchange initial receipts from the bond issues (they would
most likely be equal) and the U.S. company would then pay the
interest and repay the principal of the US$-denominated bonds
issued by the German company. The German company would do
likewise on the DM-denominated bonds.
Remember that the swap only makes sense if both companies can
lower their all-in-cost of borrowing funds. Also remember that a
bank or some other intermediary will usually be part of the
arrangement and will charge fees for its service.
UNIT SUMMARY
An option is a contract between a buyer and a seller. A call option
gives the buyer the right to buy an asset. A put option gives the buyer
the right to sell an asset. The underlying asset is the specific asset
named in the option contract. Exercising the option is either the
buying or the selling of the underlying asset.
An option is in the money when it produces a profit at the time of
exercise. An option is out of the money when it does not produce a
profit at the time of exercise.
An American option gives the right to exercise the option at any
time up to the expiration date. European option gives the right to
exercise the option only on the expiration date.
The Option Clearing Corporation (OCC) is the clearinghouse for
options trading.
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Call holders and put writers post margin money with brokers to
assure performance of investors' obligations. A margin call requires
the deposit of additional funds into the margin account.
A swap is an exchange of cash flows between two counterparties.
An interest rate swap is used by a company to meet the need for
fixed or floating interest rates at lower rates than may be available in
the market.
A foreign currency swap is a method for companies to borrow at a
lower rate in one currency than in another currency.
Swaps are arranged through an intermediary and are intended to
reduce the borrowing costs for both counterparties.
Congratulations! You have completed the Basics of Corporate Finance course. Please
complete the final Progress Check which follows to check your understanding of
securities.
You have studied the basic concepts and calculations that are the foundation for future
courses related to corporate finance and the capital and derivative markets. You should
now have a strong working vocabulary for the financial world and an understanding of the
basic types of analyses used in the corporate finance field. The index and glossary are
provided to help you use this workbook as an easy reference in the future. Use it as you
pursue more advanced courses in the corporate finance series.
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4 PROGRESS CHECK 10
Directions: Select the correct answer for each question. Check your solution with the
Answer Key on the next page. If you are not able to complete the Progress
Check correctly, read the appropriate text again.
1. Match the terms in Column A with the correct definition in Column B.
Column A Column B
A. Underlying asset An exchange of cash flows between two
counterparties
B. Exercising the option The specific asset named in the option
contract
C. Margin money The right to buy an asset
D. Interest rate swap The right to sell an asset
E. Put The buying or selling of the underlying asset
F. Call When the option produces a profit at the time
of exercise
G. In the money Price at which underlying asset may be
bought or sold
H. Strike price Account maintained by investors with brokers
to assure performance of investors'
obligations
2. The holder of an American call option:
_____a) must exercise the option on the expiration date.
_____b) is obligated to exercise the option either on or before the expiration
date.
_____c) may exercise the option only on the exercise date.
_____d) has the right to exercise on or before the exercise date.
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ANSWER KEY
1. Match the terms in Column A with the correct definition in Column B.
Column A Column B
A. Underlying asset
D An exchange of cash flows between two
counterparties
B. Exercising the option
A The specific asset named in the option
contract
C. Margin money
F The right to buy an asset
D. Interest rate swap
E The right to sell an asset
E. Put
B The buying or selling of the underlying asset
F. Call
G When the option produces a profit at the time
of exercise
G. In the money H Price at which underlying asset may be bought
or sold
H. Strike price
C Account maintained by investors with brokers
to assure performance of investor's obligations
2. The holder of an American call option:
d) has the right to exercise on or before the exercise date.
The holder has the right to exercise the option on or before the exercise date,
not the obligation.
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PROGRESS CHECK
(Continued)
3. The only loss sustained by the holder of a call that expires "out of the money" is the:
_____a) difference between the strike price and the price of the underlying
asset.
_____b) value of the stock if the price drops to $0.
_____c) premium paid for the call option.
_____d) amount of the strike price.
4. Select a condition that may allow an interest rate swap between two companies to be
profitable.
_____a) Floating rates are expected to rise because of inflation.
_____b) The credit rate differential spread between fixed and floating rates for
the two companies is significant.
_____c) There is a significant difference between U.S. Treasury bill and U.S.
Treasury bond rates.
_____d) Fixed rates are expected to fall.
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ANSWER KEY
3. The only loss sustained by the holder of a call that expires "out of the money" is the:
c) premium paid for the call option.
The holder of an option is only liable for the price paid for the option. If the option
expires "out of the money," he is not required to exercise the option and incur
additional losses.
4. Select a condition that may allow an interest rate swap between two companies to be
profitable:
b) The credit rate differential spread between fixed and floating rates
for the two companies is significant.
This condition may allow both companies to lower their cost of debt, provided
that one needs floating-rate and the other needs fixed-rate. Also the
calculations must include the intermediary and its fees.
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PROGRESS CHECK
(Continued)
5. In an interest rate swap transaction, the notional principal is:
_____a) exchanged between the two parties at the beginning of the agreement
and again on the maturity date.
_____b) loaned by one counterparty to the other in exchange for either fixed or
floating rate interest.
_____c) never exchanged between the counterparties.
_____d) different for both counterparties.
6. Consider the rates available in the market to Mega Corporation and Super, Inc.
Fixed Rate Floating Rate
Mega Corporation 9.00% LIBOR + 1.5%
Super, Inc. 11.25% LIBOR + 2.25%
Currently, Mega Corporation is paying 9.00% to bondholders, but it wants to
replace this fixed rate financing with floating rate financing. Super, Inc. pays
LIBOR + 2.25% to investors in need of fixed rate financing. Super agrees to
pay Mega fixed rate payments of 9%; Mega agrees to pay Super floating rate
payments of LIBOR + 0.75%. How much would each company save on the
financing it needs by entering into a fixed / floating rate swap transaction?
Mega _____________%
Super _____________%
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ANSWER KEY
5. In an interest rate swap transaction, the notional principal is:
c) never exchanged between the counterparties.
6. Consider the rates available in the market to Mega Corporation and Super, Inc.
Fixed Rate Floating Rate
Mega Corporation 9.00% LIBOR + 1.5%
Super, Inc. 11.25% LIBOR + 2.25%
Currently, Mega Corporation is paying 9.00% to bondholders, but it wants
to replace this fixed rate financing with floating rate financing. Super, Inc.
pays LIBOR + 2.25% to investors in need of fixed rate financing. Super
agrees to pay Mega fixed rate payments of 9%; Mega agrees to pay Super
floating rate payments of LIBOR + 0.75%. How much would each company
save on the financing it needs by entering into a fixed / floating rate swap
transaction?
Mega 0.75% a
Super 0.75% a
Cash Flow Mega Corporation Super, Inc.
Payment to investors - 9.00% - LIBOR + 2.25%
Pays in swap - LIBOR + 0.75% - 9.00%
Receives in swap +9.00% +LIBOR + 0.75%
Net payment - LIBOR + 0.75% - 10.50%
Rate available in market LIBOR + 1.50% Floating 11.25% Fixed
Net payment in swap LIBOR + 0.75% a 10.50% a
Savings 0.75% Floating 0.75% Fixed
Both companies save 0.75% by entering into an interest rate swap to get the
type of funding they need.
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Appendices
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