An interest rate swap is an agreement to exchange interest rate cash flows, typically involving one party paying a fixed rate in exchange for a floating rate from the other party. A currency swap involves exchanging principal amounts in different currencies and paying interest on those principal amounts. Swaps allow parties to transform fixed rate assets and liabilities into floating rate, or vice versa, based on their comparative advantage in borrowing costs in fixed vs floating markets. Swaps can be valued as a portfolio of forward contracts or by comparing the values of fixed and floating rate bonds.

1. Swaps Chapter 7

4. Cash Flows to Microsoft (See Table 7.1, page 151) ---------Millions of Dollars--------- LIBOR FLOATING FIXED Net Date Rate Cash Flow Cash Flow Cash Flow Mar.5, 2004 4.2% Sept. 5, 2004 4.8% +2.10 – 2.50 – 0.40 Mar.5, 2005 5.3% +2.40 – 2.50 – 0.10 Sept. 5, 2005 5.5% +2.65 – 2.50 +0.15 Mar.5, 2006 5.6% +2.75 – 2.50 +0.25 Sept. 5, 2006 5.9% +2.80 – 2.50 +0.30 Mar.5, 2007 6.4% +2.95 – 2.50 +0.45

6. Intel and Microsoft (MS) Transform a Liability (Figure 7.2, page 152) Intel MS LIBOR 5% LIBOR+0.1% 5.2%

7. Financial Institution is Involved (Figure 7.4, page 153) F.I. LIBOR LIBOR LIBOR+0.1% 4.985% 5.015% 5.2% Intel MS

8. Intel and Microsoft (MS) Transform an Asset (Figure 7.3, page 153) Intel MS LIBOR 5% LIBOR-0.2% 4.7%

9. Financial Institution is Involved (See Figure 7.5, page 154) Intel F.I. MS LIBOR LIBOR 4.7% 5.015% 4.985% LIBOR-0.2%

10. Quotes By a Swap Market Maker (Table 7.3, page 155) 6.850 6.87 6.83 10 years 6.665 6.68 6.65 7 years 6.490 6.51 6.47 5 years 6.370 6.39 6.35 4 years 6.225 6.24 6.21 3 years 6.045 6.06 6.03 2 years Swap Rate (%) Offer (%) Bid (%) Maturity

12. The Swap (Figure 7.6, page 158) AAACorp BBBCorp LIBOR LIBOR+1% 3.95% 4%

13. The Swap when a Financial Institution is Involved (Figure 7.7, page 158) AAACorp F.I. BBBCorp 4% LIBOR LIBOR LIBOR+1% 3.93% 3.97%

22. The Cash Flows (Table 7.7, page 166) Year Dollars Pounds $ ------millions------ 2004 – 15.00 +10.00 2005 +0.60 – 0.70 2006 +0.60 – 0.70 2007 +0.60 – 0.70 2008 +0.60 – 0.70 2009 +15.60 − 10.70 £