ix: market innovations 28: interest rate agreements

IX: Market Innovations

28: Interest Rate Agreements

Chapter 27: Swap Agreements © Oltheten & Waspi 2012

Interest Rate Agreements

Ceiling The buyer pays a premium and in return is

compensated if the interest rate rises above the ceiling.

Floor The buyer pays a premium and in return is

compensated if the interest rate falls below the floor.


Ceiling

Cemex Inc buys a ceiling from the Citibank The reference rate is LIBOR The ceiling is set at 6% The notional principal amount is $10m The agreement calls for quarterly settlement

for 1 year. The agreement is signed January 1, 2007


CeilingDate LIBOR Payment to Cemex

April 1, 2007 5.9% $0.

July 1, 2007 6.1% 0.1% x $10m 4

$2,500.

October 1, 2007 6.8% 0.8% x $10m 4

$20,000.

January 1, 2008 5.8% $0.


Ceiling

5.80%$0

6.80%$20,000

6.10%$2,500

5.9%$0

Ceiling

5.0%

5.5%

6.0%

6.5%

7.0%

1 Jan 07 1 Apr 07 1 Jul 07 1 Oct 07 1 Jan 08


Floor

5.80%$5,000

6.80%$0

6.10%$0

5.9%$2,500

Floor

5.0%

5.5%

6.0%

6.5%

7.0%

1 Jan 07 1 Apr 07 1 Jul 07 1 Oct 07 1 Jan 08

Credit Default Swaps



Total Return Swap

Separates Interest rate Risk from Credit Risk Funding Leg = variable Return Leg = fixed interest plus unrealized gain

or loss


Total Return Swap

JQ Investor $100,000 6% Discovery Café @ 100

Total Return Swap Speculative Hedge Fund @ LIBOR +0.5%


Total Return Swap

Risk: Interest Rate: LIBOR = 5.5% Credit: Discovery Café @100

Swap

Funding Leg: 5.5% + 0.5%: + $3,000 Return Leg: 6%: - $3,000

Unrealized gain: $0Net Swap Payment: $0


Total Return Swap


Swap


Unrealized gain: - $2,000Net Swap Payment: - $2,150

JQ pays his gain to the

Hedge Fund


Total Return Swap


Yields down, bond prices

should go up

but Discovery Café Bond

reflects credit risk


Total Return Swap


Swap


Unrealized gain: - - $55,000Net Swap Payment: + $54,750

Hedge Fund takes on credit risk; JQ is

compensated


Credit Default Swap

JQ Investor $100,000 6% Discovery Café @ 100

Credit Default Swap Speculative Hedge Fund CDS @1%

0.25% ($250)paid to SHF quarterly Unlike the Total Return Swap SHF pays JQ only

upon default.

Pollution Allocation Units



Natural Resource Economics

In production factors of production are used to the point where

marginal cost = marginal revenue

Economic Allocation Rights add the cost of open access natural resources back into the production function.


Pollution Rights

Sulphur Dioxide Emission Unit allows the emission of 1 ton of SO2 up to the expiration year. 1 ton SO2 emitted in 2009 must be paid for

with a 2009 SO2 unit or a banked pre-2009 unit In March of 2010 the EPA issues units based on

historical emissions and auctions 2010 and 2017 units

http://www.evomarkets.com/

http://www.evomarkets.com/


Pollution Rights

The old factory can reduce emissions by spending $500 1st ton $600 2nd ton $700 3rd & 4th ton

The new factory can reduce emissions by spending $200 1st & 2nd ton $300 3rd & 4th ton

6 tons

6 tons


Pollution Rights

Congress mandates a reduction of 2 tons by each factory.


Cost of reducing emissions

The old factory $500 1st ton $600 2nd ton $700 3rd & 4th ton

The new factory $200 1st & 2nd ton $300 3rd & 4th ton

$1,100

$400

TOTAL COST: $1,500

4 tons

4 tons



The old factory $500 1st ton $600 2nd ton $700 3rd ton


Buy 2 extra pollution credits for $400 each

TOTAL COST: $1,000

Sell 2 extra pollution credits for $400 each

6 tons

2 tons



The old factory $500 1st ton $600 2nd ton $700 3rd ton


Cost of credits $800 < $1,100

$1,000 +$800=$200$200 < $400

TOTAL COST: $1,000 < $1,500

Drop Options


Drop Options

Each student entering the College of Business will receive two Drop Options.

DROP OPTION

Entitles the student to drop one 3 hour course at any time, up to an including the last day of

class, without penalty.

Expires: May 15, 2014

Registered to: John Q. Student

Assumes four years to graduation plus one year buffer zone

Can be used by John Q. Student or sold to another student.


Drop Options

Drop Options will trade in the open market.


Drop Options

Joe is a well-motivated student who plans his program of study and follows it. He never uses his drop options.

In his final semester he sells his drop options for $300 each.


Drop Options

Susan drops Marketing 306 but sells her other drop option in hersenior year for $320.


Drop Options

Sterling Silverspoon III is drops two classes in his freshman year.

He needs two more drop options to repeat Finance 300 (twice). He pays $300 for the first and $320 for the second.

He drops Corporate Finance once ($320) and Futures and Options once ($330).

He drops Financial Engineering once ($300) and decides to take Investments instead.

The End

ix: market innovations 28: interest rate agreements

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