Corporate

Risk
Management
@ EDHEC

Prof. Schroth Corporate Risk Management

Synopsis MSc in Corporate Finance & Banking
Interest rate
swaps
EDHEC Business School
Example
The Rothmans swap

Valuing the
deal Enrique Schroth
Rothmans’ banker

Exit Professor of Finance

Summary EDHEC Business School

Rothmans, Inc.
13-14 October 2022

1 / 27
 Contents

Corporate
Risk
Management
@ EDHEC 1 Synopsis
Prof. Schroth

Synopsis 2 Interest rate swaps

Interest rate Example
swaps
Example
The Rothmans swap
The Rothmans swap

Valuing the
deal
3 Valuing the deal
Rothmans’ banker
Rothmans’ banker
Exit

Summary
4 Exit

5 Summary

2 / 27
 Rothmans Inc: Synopsis

Corporate
Risk
Management
@ EDHEC
• Rothmans Inc. is Canada’s second largest tobacco
Prof. Schroth company.
Synopsis
• It is based in Toronto, with production facilities in Quebec
Interest rate and Ontario, and it is widely held and publicly traded.
swaps
Example • In 2001, the firm levered up by buying out CAD 150
The Rothmans swap

Valuing the
million worth of outstanding stock, financed by cash raised
deal with a new floating rate long-term loan for the same
Rothmans’ banker

Exit
amount.
Summary • The risk of rising interest rates, and therefore, higher debt
service costs, was hedged with an interest rate swap,
where Rothmans Inc. was the fixed rate payer (floating
rate receiver).

3 / 27
 Rothmans Inc: Main issues

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Synopsis Q1: Was this contract an effective way to hedge the

Interest rate
swaps
risk of rising debt servive costs?
Example
The Rothmans swap
Q2: Did the company calculate or report correctly the
Valuing the fair value of the deal?
deal
Rothmans’ banker Q3: Should the firm have paid out the debt and exited
Exit the swap in 2005?
Summary

4 / 27
 What is an interest rate swap?

Corporate
Risk
Management
@ EDHEC
• In an interest rate swap two counterparties agree to
Prof. Schroth
exchange periodic interest payments.
Synopsis
• The amount of the interest payments exchanged is based
Interest rate
swaps on a predetermined notional principal amount.
Example
The Rothmans swap • One party is the fixed-rate payer or the floating-rate
Valuing the
deal receiver.
Rothmans’ banker
• The other party is either the floating-rate payer or
Exit

Summary
fixed-rate receiver.
• The frequency with which the interest rate that the
floating-rate payer must pay is called the reset frequency.

5 / 27
 The swaps market

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Synopsis • Swaps are typically over-the-counter agreements, but

Interest rate
swaps nowadays are also extensively traded in exchanges
Example
The Rothmans swap
• Swap rates are quoted as the fixed rate swapped for
Valuing the LIBOR, for each given maturity
deal
Rothmans’ banker ⇒ Swap or LIBOR curve
Exit ⇒ Bid-ask spreads are added to each leg
Summary

6 / 27
 Swap rate quotes

Corporate
Risk
Management INTEREST RATES - SWAPS
@ EDHEC Euro-€ £ Stig. SwFr US $ Yen
Feb 14 Bid Ask Bid Ask Bid Ask Bid Ask Bid Ask
Prof. Schroth 1 year 0.36 0.40 0.61 0.64 0.04 0.10 0.25 0.28 0.17 0.23
2 year 0.42 0.46 1.00 1.04 0.04 0.12 0.43 0.46 0.17 0.23
Synopsis 3 year 0.57 0.61 1.39 1.43 0.12 0.20 0.80 0.83 0.19 0.25
4 year 0.78 0.82 1.73 1.78 0.28 0.36 1.22 1.25 0.23 0.29
Interest rate
5 year 1.00 1.04 2.01 2.06 0.47 0.55 1.61 1.64 0.30 0.36
swaps
6 year 1.21 1.25 2.24 2.29 0.67 0.75 1.95 1.98 0.38 0.44
Example
The Rothmans swap
7 year 1.40 1.44 2.43 2.48 0.87 0.95 2.23 2.26 0.48 0.54
8 year 1.58 1.62 2.59 2.64 1.05 1.13 2.46 2.49 0.57 0.63
Valuing the 9 year 1.74 1.78 2.73 2.78 1.20 1.28 2.66 2.69 0.67 0.73
deal 10 year 1.88 1.92 2.84 2.89 1.33 1.41 2.82 2.85 0.77 0.83
Rothmans’ banker 12 year 2.10 2.14 3.00 3.07 1.51 1.61 3.07 3.10 0.96 1.04
Exit 15 year 2.33 2.37 3.15 3.24 1.70 1.80 3.31 3.34 1.22 1.30
20 year 2.48 2.52 3.24 3.37 1.84 1.94 3.52 3.55 1.51 1.59
Summary 25 year 2.52 2.56 3.27 3.40 1.87 1.97 3.61 3.64 1.66 1.74
30 year 2.53 2.57 3.27 3.40 1.88 1.98 3.65 3.68 1.74 1.82
Bid and Ask rates as of close of London business. £ and Yen quoted on a semi-annual actual/365 basis
against 6 month Libor with the exception of the 1Year GBP rate which is quoted annual actual against
3M Libor. Euro/Swiss Franc quoted on an annual bond 30/360 basis against 6 month Euribor/Libor.
Source: ICAP plc.

7 / 27
 Valuing swaps

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• Swap rates are determined from a condition of no
Synopsis
arbitrage
Interest rate
swaps
Example
• Either side of the contract, i.e., fixed rate payer or flexibile
The Rothmans swap rate payer, must have the same expected payoff (why?)
Valuing the
deal
Rothmans’ banker

Exit

Summary

8 / 27
 Valuing swaps

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• Swap rates are determined from a condition of no
Synopsis
arbitrage
Interest rate
swaps
Example
• Either side of the contract, i.e., fixed rate payer or flexibile
The Rothmans swap rate payer, must have the same expected payoff (why?)
Valuing the
deal
⇒ Present value of future fixed rate payments must equal
Rothmans’ banker
present value of future floating rate payments
Exit
⇒ future floating rates must be closely related to the
Summary
forward curve!

8 / 27
 Swap rates: Example

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • Consider a swap contract starting on January 1st 2014

Synopsis such that
Interest rate • notional amount is $100m;
swaps • interest payments are made quarterly;
Example
The Rothmans swap • swap term is 3 years;
Valuing the • basis for interest is 360 days;
deal
Rothmans’ banker
• the reference rate is 3-month LIBOR (supose currently is
Exit 4.05%)
Summary

9 / 27
 Swap rates: Example

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • Consider a swap contract starting on January 1st 2014

Synopsis such that
Interest rate • notional amount is $100m;
swaps • interest payments are made quarterly;
Example
The Rothmans swap • swap term is 3 years;
Valuing the • basis for interest is 360 days;
deal
Rothmans’ banker
• the reference rate is 3-month LIBOR (supose currently is
Exit 4.05%)
Summary ⇒ we need to work out the payments that each side of the
swap will pay each other.

9 / 27
 Example: 1st floating payment

Corporate
Risk
Management
@ EDHEC
• On 31st March, the first floating payment, received by the
Prof. Schroth
fixed payer, is
Synopsis

Interest rate
swaps
Notional amount × LIBOR3-month × (days/360)
Example
The Rothmans swap
= $1m × 4.05% × (90/360)
Valuing the = $1, 012, 500.
deal
Rothmans’ banker

Exit • We must now calculate the subsequent (future) floating

Summary payments ...

10 / 27
 Example: 1st floating payment

Corporate
Risk
Management
@ EDHEC
• On 31st March, the first floating payment, received by the
Prof. Schroth
fixed payer, is
Synopsis

Interest rate
swaps
Notional amount × LIBOR3-month × (days/360)
Example
The Rothmans swap
= $1m × 4.05% × (90/360)
Valuing the = $1, 012, 500.
deal
Rothmans’ banker

Exit • We must now calculate the subsequent (future) floating

Summary payments ...
• But at what rate?

10 / 27
 Example: 1st floating payment

Corporate
Risk
Management
@ EDHEC
• On 31st March, the first floating payment, received by the
Prof. Schroth
fixed payer, is
Synopsis

Interest rate
swaps
Notional amount × LIBOR3-month × (days/360)
Example
The Rothmans swap
= $1m × 4.05% × (90/360)
Valuing the = $1, 012, 500.
deal
Rothmans’ banker

Exit • We must now calculate the subsequent (future) floating

Summary payments ...
• But at what rate?
⇒ we must use the forward curve

10 / 27
 Example: Forward curve

Corporate
Risk
Management Given*data
@ EDHEC Quarter Days Forward*curve
Prof. Schroth Start*date End*date (Futures(rate)

Synopsis

Interest rate 01/01/2014 31/03/2014 90 4.05%

swaps
Example
31/03/2014 30/06/2014 91 4.15%
The Rothmans swap 30/06/2014 30/09/2014 92 4.55%
Valuing the 30/09/2014 31/12/2014 92 4.72%
deal
31/12/2014 31/03/2015 90 4.90%
Rothmans’ banker
31/03/2015 30/06/2015 91 5.03%
Exit
30/06/2015 30/09/2015 92 5.15%
Summary 30/09/2015 31/12/2015 92 5.25%
31/12/2015 31/03/2016 91 5.40%
31/03/2016 30/06/2016 91 5.50%
30/06/2016 30/09/2016 92 5.65%
30/09/2016 31/12/2016 92 5.76%

11 / 27
 Example: Step-by-step

Corporate
Risk
Step 1 Calculate the period forward rate for each
Management
@ EDHEC
maturity, e.g., for the first two quarters we have
Prof. Schroth
4.05% × (90/360) = 1.0125%
Synopsis 4.15% × (91/360) = 1.0490%
Interest rate
swaps
Example
Step 2 Calculate the period discount rate for each
The Rothmans swap maturity, e.g., for the second quarter we have
Valuing the
deal (1 + 1.0125%) × (1 + 1.0490%) − 1 = 2.0721%
Rothmans’ banker

Exit

Summary
Step 3 Calculate the period discount factor for each
maturity, e.g., for the second quarter we have
1
= 0.9797.
1 + 2.0721%

12 / 27
 Example: Discount rates

Corporate
Risk
Management
@ EDHEC Given*data Disccount*rates
Prof. Schroth Quarter Days Forward*curve Period Discount Discount
Start*date End*date (Futures(rate) forward*rate rate factor
Synopsis

Interest rate
swaps
01/01/2014 31/03/2014 90 4.05% 1.0125% 1.0125% 0.98998
Example
The Rothmans swap 31/03/2014 30/06/2014 91 4.15% 1.0490% 2.0721% 0.97970
Valuing the
30/06/2014 30/09/2014 92 4.55% 1.1628% 3.2590% 0.96844
deal 30/09/2014 31/12/2014 92 4.72% 1.2062% 4.5046% 0.95690
Rothmans’ banker 31/12/2014 31/03/2015 90 4.90% 1.2250% 5.7847% 0.94532
Exit 31/03/2015 30/06/2015 91 5.03% 1.2715% 7.1298% 0.93345
Summary 30/06/2015 30/09/2015 92 5.15% 1.3161% 8.5397% 0.92132
30/09/2015 31/12/2015 92 5.25% 1.3417% 9.9959% 0.90912
31/12/2015 31/03/2016 91 5.40% 1.3650% 11.4974% 0.89688
31/03/2016 30/06/2016 91 5.50% 1.3903% 13.0475% 0.88458
30/06/2016 30/09/2016 92 5.65% 1.4439% 14.6798% 0.87199
30/09/2016 31/12/2016 92 5.76% 1.4720% 16.3679% 0.85934

13 / 27
 Example: Step-by-step (contd.)

Corporate
Risk Step 4 Calculate the future values of the floating
Management
@ EDHEC payments, e.g., for the second quarter we have
Prof. Schroth
$1, 000, 000 × 1.0490% = $1, 049, 028.
Synopsis

Interest rate
swaps
Example
The Rothmans swap
Step 5 Calculate the present value of the floating
Valuing the payments, for the second quarter we have
deal
Rothmans’ banker
$1, 049, 028 × 0.9797 = $1, 027, 732.
Exit

Summary
and then add them up.
Step 6 Guess the swap rate, e.g., using ‘Goal seek’ and
calculate the present value of the fixed payments
as in steps 4 and 5 such that the difference
between both present values is zero.
14 / 27
 Example: Guessing the swap rate

Corporate
Risk PV%of%swapped%payments
Management Swap%rate Floating Fixed PV%of%floating PV%of%fixed
@ EDHEC
(guess) payments payments payments payments
Prof. Schroth

Synopsis
4.99% &&&&&&&&1,012,500 &&&&&&&&1,246,952 &&&&&&&&1,002,351 &&&&&&&&1,234,454
Interest rate &&&&&&&&1,049,028 &&&&&&&&1,260,807 &&&&&&&&1,027,732 &&&&&&&&1,235,212
swaps
Example
&&&&&&&&1,162,778 &&&&&&&&1,274,662 &&&&&&&&1,126,079 &&&&&&&&1,234,432
The Rothmans swap &&&&&&&&1,206,222 &&&&&&&&1,274,662 &&&&&&&&1,154,229 &&&&&&&&1,219,720
Valuing the
&&&&&&&&1,225,000 &&&&&&&&1,246,952 &&&&&&&&1,158,012 &&&&&&&&1,178,764
deal &&&&&&&&1,271,472 &&&&&&&&1,260,807 &&&&&&&&1,186,852 &&&&&&&&1,176,897
Rothmans’ banker &&&&&&&&1,316,111 &&&&&&&&1,274,662 &&&&&&&&1,212,562 &&&&&&&&1,174,374
Exit &&&&&&&&1,341,667 &&&&&&&&1,274,662 &&&&&&&&1,219,742 &&&&&&&&1,158,827
Summary
&&&&&&&&1,365,000 &&&&&&&&1,260,807 &&&&&&&&1,224,244 &&&&&&&&1,130,795
&&&&&&&&1,390,278 &&&&&&&&1,260,807 &&&&&&&&1,229,817 &&&&&&&&1,115,290
&&&&&&&&1,443,889 &&&&&&&&1,274,662 &&&&&&&&1,259,061 &&&&&&&&1,111,497
&&&&&&&&1,472,000 &&&&&&&&1,274,662 &&&&&&&&1,264,954 &&&&&&&&1,095,373

TOTAL &&&&&14,065,635 &&&&&14,065,635

Net &&&&&&&&&&&&&&&&&&&&&&&0

15 / 27
 Swap and underlying forward rates

Corporate
Risk 6.00%
Management
@ EDHEC

Prof. Schroth 5.50%

Synopsis
5.00%
Interest rate
swaps
Example
4.50%
The Rothmans swap

Valuing the
deal 4.00%
Rothmans’ banker

Exit
3.50%
Summary 3 6 9 12 15 18 21 24 27 30 33 36

Floating rate Fixed rate

⇒ The swap rate is basically the average of the forward rates

over a given maturity
16 / 27
 The Rothmans’ swap

Corporate
Risk
Management
@ EDHEC
• Rothmans’ has a fixed one-to-one exposure to the Banker’s
Prof. Schroth Acceptance rate: a 1% increase in the BA increases the
yearly interest payments by CAD$ 1.5 million.
Synopsis
• Losses from this short exposure to interest rates may be
Interest rate
swaps effectively hedged with swap where Rothman’s
Example
The Rothmans swap
• receives a floating rate based on a notional of CAD$ 150
Valuing the million and a rate closely related to the BA rate;
deal • pays a fixed rate.
Rothmans’ banker

Exit • On September 2001, it agrees to swap the BA rate + 1.5%

Summary for a 5.35% fixed rate based on a notional of CAD$75
million, on a monthly basis for five years (60 periods).
• The notional decreases to CAD$45 million in September
2004.

17 / 27
 Reconstructing the reported values

Corporate
Risk
Management
@ EDHEC

Prof. Schroth

Synopsis • The analyst has used Trombley’s (2003) method to

Interest rate approximate forward rates with spot rates ex post.
swaps
Example ⇒ You cannot use hindsight: Rothmans did not have
The Rothmans swap
spot rates data!
Valuing the
deal • Smith (the analyst) has reproduced the same calculations
Rothmans’ banker

Exit
to square his valuation with the one reported in the Notes
Summary
to the Balance Sheet

18 / 27
 Rothmans’ bankers’ calculations

Corporate
Risk
At inception (September 28, 2001):
Management
@ EDHEC

Prof. Schroth
Floating payment: 28/09/2002 28/09/2003 28/09/2004 28/09/2005 28/09/2006
Synopsis Notional Principal 75,000,000 75,000,000 45,000,000 45,000,000 45,000,000
Expected BA rate 2.900% 2.380% 2.190% 4.490% 9.640%
Interest rate
Expected floating
swaps payment @ BA+1.5% 3,300,000 2,910,000 1,660,500 2,695,500 5,013,000
Example Discount rate 3.630% 2.930% 2.880% 2.480% 3.130%
The Rothmans swap
Present Value at each
Valuing the date 3,184,406 2,746,686 1,524,916 2,443,897 4,297,072
deal Total Present Value 14,196,977
Rothmans’ banker
Fixed payment: 28/09/2002 28/09/2003 28/09/2004 28/09/2005 28/09/2006
Exit Notional Principal 75,000,000 75,000,000 45,000,000 45,000,000 45,000,000
Fixed rate of interest 5.380% 5.380% 5.380% 5.380% 5.380%
Summary
Fixed payment 4,035,336 4,035,336 2,421,202 2,421,202 2,421,202
Discount rate 3.630% 2.930% 2.880% 2.480% 3.130%

Present Value at each

date 3,893,984 3,808,867 2,223,505 2,195,202 2,075,419
Total Present Value 14,196,977

Difference in PVs 0

19 / 27
 The ‘correct’ rates

Corporate
Risk
At inception (September 28, 2001), the zero coupon curve, and
Management
@ EDHEC
the implied forward curve were actually:
Prof. Schroth Trombley's+approximation+
Actual+rates
(given)
Synopsis Maturity Forward,rate Maturity Zero,rate Forward,rate Discount,rate

Interest rate 0 2.90% 0.25 3.15% 3.15%

swaps 1 2.38% 0.5 3.00% 2.86%
2 2.19% 0.75 3.01% 3.01%
Example
3 4.49% 1 3.07% 3.27% 3.27%
The Rothmans swap
4 9.64% 1.25 3.17% 3.58%
1.5 3.30% 3.90%
Valuing the
1.75 3.43% 4.22%
deal
2 3.56% 4.51% 3.89%
Rothmans’ banker
2.25 3.70% 4.78%
2.5 3.83% 5.00%
Exit
2.75 3.95% 5.19%
Summary 3 4.07% 5.35% 4.38%
3.25 4.18% 5.48%
3.5 4.28% 5.58%
3.75 4.37% 5.67%
4 4.45% 5.73% 4.71%
4.25 4.53% 5.78%
4.5 4.60% 5.82%
4.75 4.67% 5.85%
5 4.73% 5.88% 4.94%

20 / 27
 A good deal?

Corporate
Risk
Management
@ EDHEC
• It is very difficult to reconcile Rothman’s own calculations:
Prof. Schroth a fair swap valuation should not use the historical rates
Synopsis

Interest rate
swaps
Example
The Rothmans swap

Valuing the
deal
Rothmans’ banker

Exit

Summary

21 / 27
 A good deal?

Corporate
Risk
Management
@ EDHEC
• It is very difficult to reconcile Rothman’s own calculations:
Prof. Schroth a fair swap valuation should not use the historical rates
Synopsis • If we reconstruct the forward curve at the time of the
Interest rate swap, we can recover the appriopriate Bankers’ Acceptance
swaps
Example
rates by applying the historical premium of 2bp between
The Rothmans swap
the Canadian Zero Coupon yield and BA + 1.5%
Valuing the
deal • The fair rate would have been more like 4.7% to 5%!
Rothmans’ banker

Exit
⇒ the bank can profit from discount rate uncertainty!
Summary • In any case, the reported discount rates are too low and
the reported forward rates are too high

21 / 27
 A good deal?

Corporate
Risk
Management
@ EDHEC
• It is very difficult to reconcile Rothman’s own calculations:
Prof. Schroth a fair swap valuation should not use the historical rates
Synopsis • If we reconstruct the forward curve at the time of the
Interest rate swap, we can recover the appriopriate Bankers’ Acceptance
swaps
Example
rates by applying the historical premium of 2bp between
The Rothmans swap
the Canadian Zero Coupon yield and BA + 1.5%
Valuing the
deal • The fair rate would have been more like 4.7% to 5%!
Rothmans’ banker

Exit
⇒ the bank can profit from discount rate uncertainty!
Summary • In any case, the reported discount rates are too low and
the reported forward rates are too high ⇒ the likely
scenario is that the bank overstated the forward rate in
order to increase the ‘fair’ swap rate.

21 / 27
 CRM student’s calculations 1.5% premium
on BA rate (approx)
Corporate
Risk
At inception (September 28, 2001):
Management
@ EDHEC

Prof. Schroth
Floating payment: 28/09/2002 28/09/2003 28/09/2004 28/09/2005 28/09/2006
Synopsis Notional Principal 75,000,000 75,000,000 45,000,000 45,000,000 45,000,000
Expected base rate 3.272% 4.513% 5.353% 5.729% 5.880%
Interest rate
Expected floating
swaps payment @ BA+1.5% 2,471,271 3,402,679 2,419,319 2,588,465 2,656,480
Example Discount rate 3.295% 3.914% 4.399% 4.736% 4.968%
The Rothmans swap
Present Value at each
Valuing the date 2,392,440 3,151,171 2,126,186 2,151,103 2,084,568
deal Total Present Value 11,905,468
Rothmans’ banker
Fixed payment: 28/09/2002 28/09/2003 28/09/2004 28/09/2005 28/09/2006
Exit Notional Principal 75,000,000 75,000,000 45,000,000 45,000,000 45,000,000
Fixed rate of interest 4.681% 4.681% 4.681% 4.681% 4.681%
Summary
Fixed payment 3,510,969 3,510,969 2,106,581 2,106,581 2,106,581
Discount rate 3.295% 3.914% 4.399% 4.736% 4.968%

Present Value at each

date 3,398,972 3,251,456 1,851,341 1,750,642 1,653,057
Total Present Value 11,905,468

Difference in PVs -

22 / 27
 Hedging performance

Corporate
Risk
Management
@ EDHEC • Between initiation and March 2002, the swap performs
Prof. Schroth well: interest rates increase for most maturities
Synopsis

Interest rate
swaps
Example
The Rothmans swap

Valuing the
deal
Rothmans’ banker

Exit

Summary

23 / 27
 Hedging performance

Corporate
Risk
Management
@ EDHEC • Between initiation and March 2002, the swap performs
Prof. Schroth well: interest rates increase for most maturities
Synopsis
⇒ the new swap rate would be higher, at least 5.59%;
Interest rate • However, the estimated future gains on the present value
swaps
Example of the swap, of CAD$ 526 thousand, are to be partially
The Rothmans swap
offset with losses on the exposure!
Valuing the
deal ⇒ next payments due are based on latest BA rate, which
Rothmans’ banker
is higher.
Exit

Summary
⇒ some hedging has been provided already.

23 / 27
 Hedging performance

Corporate
Risk
Management
@ EDHEC • Between initiation and March 2002, the swap performs
Prof. Schroth well: interest rates increase for most maturities
Synopsis
⇒ the new swap rate would be higher, at least 5.59%;
Interest rate • However, the estimated future gains on the present value
swaps
Example of the swap, of CAD$ 526 thousand, are to be partially
The Rothmans swap
offset with losses on the exposure!
Valuing the
deal ⇒ next payments due are based on latest BA rate, which
Rothmans’ banker
is higher.
Exit

Summary
⇒ some hedging has been provided already.
• The decision to exit or stay with the swap must depend on
the future expected value of the swap, and the costs of
exiting, not on the losses or gain to date.

23 / 27
 Exiting in 2005

Corporate
Risk
Management
@ EDHEC

Prof. Schroth
• Between 2004 and 2005, Rothmans’ refinances the
existing debt of CAD$ 150 million by
Synopsis
• Privately placing two tranches of semi-annual
Interest rate
swaps coupon-paying bonds, at an average rate of 5.552%;
Example • Exiting the swap contract, with associated penalties and
The Rothmans swap
current fair value!
Valuing the
deal • Such a strategy implies
Rothmans’ banker

Exit
• refinancing all the debt at a higher cost than the current
Summary
swap rate on 30% of the total debt;
• pay the bank at least the fair value of the swap, i.e., over
CAD$2 million plus penalties.

24 / 27
 Why exit then?

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • Rothmans may have exited the contract because:

• It thought more losses on the fair value would be
Synopsis

Interest rate
sustained, so better to switch to a new fixed rate financing
swaps (even if more expensive);
Example
The Rothmans swap

Valuing the
deal
Rothmans’ banker

Exit

Summary

25 / 27
 Why exit then?

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • Rothmans may have exited the contract because:

• It thought more losses on the fair value would be
Synopsis

Interest rate
sustained, so better to switch to a new fixed rate financing
swaps (even if more expensive);
Example
The Rothmans swap
⇒ but the swap was only on 30% of the debt, and
Valuing the
deal
Rothmans’ banker

Exit

Summary

25 / 27
 Why exit then?

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • Rothmans may have exited the contract because:

• It thought more losses on the fair value would be
Synopsis

Interest rate
sustained, so better to switch to a new fixed rate financing
swaps (even if more expensive);
Example
The Rothmans swap
⇒ but the swap was only on 30% of the debt, and
Valuing the
⇒ in any case, it was a hedge, i.e., fair value losses on the
deal swap would be more than offset with the short exposure
Rothmans’ banker
via the floating rate loan!
Exit

Summary

25 / 27
 Why exit then?

Corporate
Risk
Management
@ EDHEC

Prof. Schroth • Rothmans may have exited the contract because:

• It thought more losses on the fair value would be
Synopsis

Interest rate
sustained, so better to switch to a new fixed rate financing
swaps (even if more expensive);
Example
The Rothmans swap
⇒ but the swap was only on 30% of the debt, and
Valuing the
⇒ in any case, it was a hedge, i.e., fair value losses on the
deal swap would be more than offset with the short exposure
Rothmans’ banker
via the floating rate loan!
Exit
• Very likely that Rothman’s underestimated the costs of
Summary
exit, considering only the CAD$223,000 penalty and not
the fair value going forward.

25 / 27
 Forward curve movements

Corporate
Risk
Management
@ EDHEC 0.07
Prof. Schroth
0.06
Synopsis

Interest rate 0.05

For w ar d r at e s

swaps
Example
The Rothmans swap
0.04

Valuing the
deal 0.03
Rothmans’ banker

Exit 0.02
Summary
0.01 September 28, 2001
March 31, 2002
December 31, 2004
0
0 1 2 3 4 5
Mat ur it ie s ( ye ar s)

26 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap
Synopsis

Interest rate
swaps
Example
The Rothmans swap

Valuing the
deal
Rothmans’ banker

Exit

Summary

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
swaps
Example
The Rothmans swap

Valuing the
deal
Rothmans’ banker

Exit

Summary

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
• The swap was expensive, priced above the fair swap rate.
swaps
Example
The Rothmans swap

Valuing the
deal
Rothmans’ banker

Exit

Summary

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
• The swap was expensive, priced above the fair swap rate.
swaps
Example
• The bank seems to have provided Rothmans’ with an
The Rothmans swap
incorrect valuation. Was this deliberate?
Valuing the
deal
Rothmans’ banker

Exit

Summary

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
• The swap was expensive, priced above the fair swap rate.
swaps
Example
• The bank seems to have provided Rothmans’ with an
The Rothmans swap
incorrect valuation. Was this deliberate? Yes.
Valuing the
deal
Rothmans’ banker

Exit

Summary

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
• The swap was expensive, priced above the fair swap rate.
swaps
Example
• The bank seems to have provided Rothmans’ with an
The Rothmans swap
incorrect valuation. Was this deliberate? Yes.
Valuing the
deal • The swap nevertheless performed well as a hedging
Rothmans’ banker
instrument but
Exit
• Rothmans’ never hedged fully, suggesting it constructed a
Summary
hedge with views that interest rates would drop

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
• The swap was expensive, priced above the fair swap rate.
swaps
Example
• The bank seems to have provided Rothmans’ with an
The Rothmans swap
incorrect valuation. Was this deliberate? Yes.
Valuing the
deal • The swap nevertheless performed well as a hedging
Rothmans’ banker
instrument but
Exit
• Rothmans’ never hedged fully, suggesting it constructed a
Summary
hedge with views that interest rates would drop (true, but
not the point!)

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
• The swap was expensive, priced above the fair swap rate.
swaps
Example
• The bank seems to have provided Rothmans’ with an
The Rothmans swap
incorrect valuation. Was this deliberate? Yes.
Valuing the
deal • The swap nevertheless performed well as a hedging
Rothmans’ banker
instrument but
Exit
• Rothmans’ never hedged fully, suggesting it constructed a
Summary
hedge with views that interest rates would drop (true, but
not the point!)
• Rothmans misgauged the exit costs and refinanced poorly.

27 / 27
 Summary

Corporate
Risk
Management
@ EDHEC
• Rothmans’ did well initially by hedging a large floating
Prof. Schroth rate exposure using an interest rate swap ⇒ it allowed the
firm to increase leverage and exploit tax shields!
Synopsis

Interest rate
• The swap was expensive, priced above the fair swap rate.
swaps
Example
• The bank seems to have provided Rothmans’ with an
The Rothmans swap
incorrect valuation. Was this deliberate? Yes.
Valuing the
deal • The swap nevertheless performed well as a hedging
Rothmans’ banker
instrument but
Exit
• Rothmans’ never hedged fully, suggesting it constructed a
Summary
hedge with views that interest rates would drop (true, but
not the point!)
• Rothmans misgauged the exit costs and refinanced poorly.
(pressure to keep up with a high dividend policy?)

27 / 27