BF RaboBank (1)

The B.F. Goodrich-Rabobank Interest Rate Swap

Motivations for Interest Rate Swaps 1. Interest rate risk management

Match the asset cash flow and maturity structure with the liability cash flow and maturity structure . !rbitrage "rofits based on comparative cost advantage

Cost

Doris

Apples

Oranges

20 cents

30 cents

Jeremy 30 cents 50 cents  Doris!s ad"antage #0 cents 20 cents Comparati"e ad"antage $ 20 % #0 $ #0 cents per fruit Doris li&es apples and Jeremy li&es oranges' Doris would li&e to eat three apples a day' Jeremy would li&e to eat three oranges a day (ithout trading Doris must spend )0 cents a day (ithout trading Jeremy must spend *#'50 a day

Doris and Jeremy do an Apple+Orange ,wap Doris buys three oranges and Jeremy buys three apples' -hey swap their fruits' Doris spends 3 . 30 $ /0 cents Jeremy spends 3 . 30 $/0 cents Jeremy pays 5 cents to Doris Doris!s cost $ /0 % 5 $ 5 cents Jeremy!s cost $ /0 1 5 $ *#'35 oth sa"e #5 cents' -ogether they sa"e 30 cents which is eual to the comparati"e ad"antage per fruit of #0 cents times 3 fruits'

The Interest Rate Swap

Rabobank#s $omparative $ost !dvantage

6aboban& 7AAA8

4ied

4loating

#0'90

:;O6 1 0'25<

'4' =oodrich 7-8 #2'5< :;O6 1 0'5<  6aboban&!s #'>< 0'25< ad"antage Comparati"e ad"antage $ #'><  0'25< $ #'55< p'a'

6aboban& needs floating rate financing to support its ?',' dollardenominated floating rate loans' '4' =oodrich needs fied rate financing for long term to support its deteriorating financial condition'

(ho should borrow in which mar&et@

$ost of Financing Before the swap% 6aboban& cost of financing $ :;O6 10'25< '4' =oodrich cost of financing $ #2'5<

!fter the Swap 6aboban& cost of financing $ #0'9< 7interest to in"estors in etherlands8 1 7:;O6  8 7swap payments to Morgan8  7#0'9<8 7swap payments recei"ed from Morgan8  $ :;O6  

'4' =oodrich cost of financing $ :;O6 10'5< 7interest to in"estors in the ?','8 1 #0'9< 1 4 7swap payments plus fee to Morgan8  7:;O6  8 7swap payments recei"ed from Morgan8  $ ##'2< 1 4 1 

Swap Transaction Savings 6aboban& sa"ings $ 0'25< 1  B 0 '4' =oodrich sa"ings $ #'3<  4   B 0 Morgan!s fee $ 4 B 0  -otal $ #'55< $ Comparati"e cost ad"antage

Minim&m and Ma'im&m for ' and F

 should be greater than 0'25< 7otherwise no incenti"e for 6aboban&8  should be less than #'3< 7otherwise no incenti"e for '4' =oodrich and+or Morgan8 4 should be greater than ero 7otherwise no incenti"e for Morgan8 4 should be less than #'55< 7otherwise no incenti"e for 6aboban& and+or '4' =oodrich8 enceE 0'25< F  F #'3< And 0 F 4 F #'55<

(ther Iss&es #' Default 6is&  2' -he e"olution of interest rate swaps 3' Deri"ati"e eposure of firms

)&estions% G#' (hat are the moti"ating reasons for the interest rate swap in the current case@ G2' Draw the swap diagram' G3' Assuming hypothetical :ibor ratesE show the echange of dollar cash flows' G' ,how how the swap transaction sa"ings might be shared among the three parties'