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FINANCIAL INSTRUMENTS
1. Interest Rate Caps 2. Currency Swaps

Presented by: Shruti Sood

INTEREST RATE CAPS

A derivative in which buyer receives payments at the end of each period in which the interest rate exceeds the agreed ceiling rate. TERMINOLOGY
Writer of cap/cap dealer Cap holder Reference rate Ceiling rate/ strike price Premium Notional principal Tenor Settlement dates

IF DEALER IS CAP HOLDER

Dealer pays = D X Max [Reference Ceiling, 0] NP X LPP

Where, D =

NP = LPP =

Dummy variable that takes value +1 if dealer is cap seller and -1 if dealer is cap purchaser. Notional principal Length of the payment period

PAY-OFF PROFILE FOR A CAP PURCHASER

Profit MAX [Reference Ceiling, 0] X NP X LPP Ceiling rate Reference Rate

Pre-period premium (Amortized)

EXAMPLE
Date of purchasing cap Tenor Reference rate Ceiling rate Notional principal Settlement dates :15/8/2011 :5 years :6-M LIBOR :10% :$50 million :15th February and 15thAugust

SERIES OF PAYMENT ON THE CAP

VALUE OF THE PAYMENT VALUE OF CEILING DATE REFERENCE RATE RATE 15/02/2012 10.48 10 LPP 184/360 PAYMENT ($) 122,667

15/08/2012
15/02/2013 15/08/2013 15/02/2014 15/08/2014 15/02/2015 15/08/2015 15/02/2016 15/08/2016 TOTAL

9.89
9.24 8.56 9.78 10.18 10.94 12.34 11.08 9.67

10
10 10 10 10 10 10 10 10

182/360
183/360 182/360 183/360 182/360 183/360 182/360 184/360 184/360

45,500 238,917 591,500 276,000 1,274,583

ADVANTAGES

DISADVANTAGES

Suitable when risk exposure spans multiple periods. Allows investor to benefit from interest rate changes while also limiting downside losses. Guarantees the investors maximum interest expenses. Can be sold at any time.

The buyer must pay the premium. Lower the ceiling rate, higher shall be the premium.

CURRENCY SWAPS
First currency swap engineered in London in 1979 Salmon Brothers put together currency swap involving the World Bank and IBM.

FEATURES
Two payment streams being exchanged denominated in different currencies. Exchange of principal at the beginning & reexchange at the termination.
COMPANY A REQUIREMENT S FRANCS FUNDING COMPANY B AUSTRALIAN DOLLAR FUNDING

Cost of Aus Dollar 15% Funding

Cost of Francs Funding 11%

16%
10%

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CURRENCY SWAP PROCESS

Company A borrows debt in Aus Dollars @ 15% and company B borrows debt in Francs Dollars @ 10%. The 2 companies exchange debt with each other with the help of an intermediary. Bank shares in the savings of 1% involved in the swaps. Thus, net savings for the companies is less than 1%.

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Spot exchange rate : 5 Francs per 1 AUD Execution of deal worth 100 million AUD. Company A enters into swap with bank @ 15.2% and company B @ 10.2%. Thus, effective savings of both companies @ 0.8%.
TIME TRANSA COMPA CTION NY B BANK COMPA NY A

Original loan
A to Bank Bank to B

500 million
(500)

500 (500)

500

Interest payments A to Bank Bank to B 50 51 (50) (51) -

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ADVANTAGES

DISADVANTAGES

Access to market with cheaper sources of funds. Reduction in exchange risk exposures.

Default by one party leaves currency exposure. Expensive to terminate.