In this chapter, we will dwell more into interest rate risk and swaps, since they constitute the core of international finance. Interest rate risk is defined as the risk of interest rates changing unfavorably before the swap bank can lay off on an opposing counterparty the other side. Consider the following example. _____________________________________________________________________________________ Example -1- ______________________________________________________________________________________ Issue Eurodollar bonds at 10% Issue Domestic Bonds at 11.25% 10.375% 10.50% = Bank A AAA U.K. Swap Bank Bank B BBB U.S. LIBOR LIBOR = Issue FRN in $ at LIBOR Issue FRN in $ at LIBOR + .50% _____________________________________________________________________________________ Net Cash Outflows Bank A Swap Bank Company B Pays LIBOR 10.375% 10.50% 10% LIBOR LIBOR + .50% Receives -10.375% -10.50% -LIBOR LIBOR Net LIBOR - .375% -.125% 11% ______________________________________________________________________________________ In the above example, the swap bank earns a spread of .125%. Company B passes through to the swap bank 10.50 percentage per annum (on the notional principal of $10,000,000) and receives LIBOR percent in return. Bank A passes through to the swap bank LIBOR percent and receives 10.375 percent in return. Suppose the swap bank entered into the position with Company B first. If fixed rates increase substantially, say, by .50 percent, Bank A will not be willing to enter into the opposite side of the swap unless it receives, say 10.875 percent. This would make the swap unprofitable for the swap bank. Having covered this example, come up with your own numbers illustrating the example above and expliang your answer, under what conditions in your example swap be unprofitable? Explain the following, give examples for each.

Basis risk Exchange-rate risk Mismatch risk Sovereign risk What are the two primary reasons for a counterparty to use a currency swap? What are the two primary reasons for swapping interest rates? Market completeness and efficiency of swap markets. In your opinion is the swap market efficient? Alpha and Beta companies can borrow for a five year term at the following rates Alpha Beta Moodys credit rating Aa Baa Fixed rate borrowing cost 10.5% 12.0% Floating rate borrowing cost LIBOR LIBOR + 1% a.) Calculate the quality spread differential (QSD) b.) Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. No swap bank is involved in this transaction.