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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 advantage Cost Doris

Apples

Oranges

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 Doris buys three oranges and Jeremy buys three apples. 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

Rabobank’s Comparative Cost Advantage

Rabobank (AAA)

Fixed

Floating

10.70

LIBOR + 0.25%

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