Review the ABS swaps attachment and design a swap that could potentially be used in your company acquisition in the following countries: Japan, China, and the United Kingdom (UK). In a 3-5 APA paper provide an analysis to Dorchester, Inc. management advising them of the swap options you have selected and why it would be suitable for the acquisition.
Swap Funds Flows in a Typical Asset Backed Commercial paper Conduit:
In the above example, The Issuer sells receivables to a Special Purpose Vehicle that is a bankruptcy-remote entity. This means that it cannot be consolidated into the bankruptcy estate of the Issuer if the Issuer were to file for bankruptcy. The SPV issues Certificates to the Conduit in exchange for cash. The conduit raises the cash to pay for the Certificates by issuing commercial paper.
The Swap transaction is required because the portfolio of receivables that has been sold and converted into Certificates is a portfolio of fixed rate receivables. They are being funded with floating rate commercial paper creating an interest mismatch – fixed pool of assets funded by floating rate debt. The Pay-Fixed swap hedges this interest rate risk for the SPV.
The SPV will enter into a pay fixed swap with a Swap Counter-party. The SPV will pay a fixed rate of interest on the amortizing pool balance thereby hedging its interest rate risk. It will receive LIBOR (usually 30 day). The swap counter-party will settle on a net basis with the SPV each month, see below:
The above table shows the netting of the “Pay-Fixed” and “Get Floating” each month. It also points out the basis risk that this Issuer is assuming. The Basis risk stems from paying the conduit’s Commercial Paper rate as one floating rate basis while the corresponding receiving floating rate of interest is based on 30 day LIBOR. To the extent that LIBOR is greater than the commercial paper rate the Issuer benefits as it gets more than it gives. However if the opposite occurs, LIBOR is less than the conduit’s Commercial Paper rate, then it experiences increased interest costs as it is now getting less than it is giving. There are no practical ways to hedge this basis risk as every conduit’s commercial paper trades differently.