the bf goodrich-rabobank.doc

The B.F. Goodrich-Rabobank Interest Rate Swap Motivations for Interest Rate Swaps1. Interest rate risk managementMatch the asset cash flow and maturity structure with the liability cash flow and maturity structure2. Arbitrage Profits based on comparative cost advantageCostApplesOrangesDoris20 cents 30 centsJeremy30 cents 50 cents -Doriss advantage10 cents20 centsComparative 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 dayWithout trading Doris must spend 60 cents a dayWithout trading Jeremy must spend $1.50 a day Doris and Jeremy do an Apple/Orange SwapDoris buys three oranges and Jeremy buys three apples. They swap their fruits. Doris spends 3 X 30 = 90 centsJeremy spends 3 X 30 =90 cents Jeremy pays 45 cents to Doris Doriss cost = 90 45 = 45 centsJeremys 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 SwapRabobanks Comparative Cost Advantage Fixed FloatingRabobank (AAA) 10.70LIBOR + 0.25%B.F. Goodrich (BBB-) 12.5%LIBOR + 0.5%-Rabobanks 1.8%0.25%advantageComparative 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 SwapRabobank cost of financing = 10.7% (interest to investors in Netherlands)+ (LIBOR - x) (swap payments to Morgan)- (10.7%)(swap payments received from Morgan)-= LIBOR - xB.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 SavingsRabobank savings = 0.25% + x 0B.F. Goodrich savings = 1.3% - F - x 0Morgans fee = F 0-Total = 1.55% = Comparative cost advantageMinimum and Maximum for x and Fx 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 Issues1. Default Risk2. The evolution of interest rate swaps3. Derivative exposure of firmsQuestions:Q1. What are the motivating reasons for the interest rate swap in the current case?Q2. Draw the swap diagram. Q3. Assuming hypo