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# BF-RaboBank

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```									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

2. Arbitrage Profits based on comparative cost

Cost
Apples                     Oranges

Doris                      20 cents                   30 cents

Jeremy                     30 cents                    50 cents
-------------------------------------------------------------------
Doris’s advantage          10 cents                   20 cents

Comparative advantage = 20 – 10 = 10 cents per fruit

Doris likes apples and Jeremy likes oranges. Doris
would like to eat three apples a day. Jeremy would like
to eat three oranges a day

Without trading Doris must spend 60 cents a day
Without trading Jeremy must spend \$1.50 a day
Doris and Jeremy do an Apple/Orange Swap

They swap their fruits.

Doris spends 3 X 30 = 90 cents
Jeremy spends 3 X 30 =90 cents

Jeremy pays 45 cents to Doris

Doris’s cost = 90 – 45 = 45 cents
Jeremy’s cost = 90 + 45 = \$1.35

Both save 15 cents. Together they save 30 cents which is
equal to the comparative advantage per fruit of 10 cents
times 3 fruits.
The Interest Rate Swap

Fixed               Floating

Rabobank (AAA)              10.70               LIBOR + 0.25%

B.F. Goodrich (BBB-) 12.5%                       LIBOR + 0.5%
----------------------------------------------------------------------
Rabobank’s                   1.8%                     0.25%

Comparative advantage = 1.8% - 0.25% = 1.55% p.a.

Rabobank needs floating rate financing to support its U.S.
dollar-denominated floating rate loans.

B.F. Goodrich needs fixed rate financing for long term to
support its deteriorating financial condition.

Who should borrow in which market?
Cost of Financing

Before the swap:
Rabobank cost of financing = LIBOR +0.25%
B.F. Goodrich cost of financing = 12.5%

After the Swap
Rabobank cost of financing =
10.7%              (interest to investors in Netherlands)
+ (LIBOR - x) (swap payments to Morgan)
- (10.7%)          (swap payments received from Morgan)
------------------
= LIBOR - x

B.F. Goodrich cost of financing =
LIBOR +0.5% (interest to investors in the U.S.)
+ 10.7% + F           (swap payments plus fee to Morgan)
- (LIBOR - x)         (swap payments received from Morgan)
---------------------
= 11.2% + F + x
Swap Transaction Savings

Rabobank savings = 0.25% + x > 0
B.F. Goodrich savings = 1.3% - F - x > 0
Morgan’s fee = F > 0
----------------------------------------------------------------------
Total = 1.55% = Comparative cost advantage

Minimum and Maximum for x and F

x should be greater than -0.25% (otherwise no incentive
for Rabobank)
x should be less than 1.3% (otherwise no incentive for
B.F. Goodrich and/or Morgan)

F should be greater than zero (otherwise no incentive for
Morgan)
F should be less than 1.55% (otherwise no incentive for
Rabobank and/or B.F. Goodrich)

Hence, -0.25% < x < 1.3%
And     0 < F < 1.55%
Other Issues

1. Default Risk
2. The evolution of interest rate swaps
3. Derivative exposure of firms

Questions:
Q1. What are the motivating reasons for the interest rate swap in the
current case?

Q2. Draw the swap diagram.

Q3. Assuming hypothetical Libor rates, show the exchange of dollar
cash flows.

Q4. Show how the swap transaction savings might be shared among the
three parties.

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