Derivative Products and Markets

Posted: August 26th, 2021

Student’s Name

Instructor’s Name

Instructor

Date

Derivative Products and Markets

Question 2

1. Template B

Table 1: Metro do Porto cash flows (Vallee et al. 1)

Notes:

Spread = Max [0.0%, (Previous spread + 2 x Max (2.0% – Euribor3M; 0.0%) + 2 x Max (Euribor3M – 6.0%; 0.0%) – Digi Coupon)]

Where Digi Coupon = 0.50%, if 2.0% < Euribor 3M<6.0%, 0.0%, for all other Euribor 3M. The spread is set to 0 from 13 March 2017 to 13 December 2008, inclusively. The spread can never be below 0.00%. The Digi Coupon for the swap is 0.50% if 2.00% < 3M EURIBOR < 6.00% otherwise Digi Coupon = 0%. Pay leg: 1.76% semi-annually (13 June and 13 December). “Spread” quarterly (13 June, 13 September, and 13 December)

• Features of the swap with Banco Santander(BST) which made it both ‘advantageous’ and ‘very risky’ to Metro do Porto(MdP)

MdP entered into long-term exotic interest rate swaps with BST between 6 June 2005 and 2 November 2007, which are commonly known as the ‘snowball’ swap. The swaps were made in ISDA Master Agreements per the English, and nine of the total swaps were the issue of the claims. Banco Santander was the floating rate payer while Metro do Porto was the fixed ratepayer. The swaps incorporated both “memory” and “mitigating” features. MdP defaulted and was sued by BST to recover the principal amount and interest (Vallee et al. 1). Thus, Mr. Justice Blair described the swap as being both advantageous and risky to Metro do Porto.

Advantageous

Metro do Porto had a considerable debt to manage, and their primary purpose of entering into the exotic swaps was to decrease the interest amount they were incurred on the principal transactions. These savings were realized and achieved mainly in the early years immediately after entering the swap. The transaction amount was meant to manage the companies’ debt as it was the best option in the market at the time of the financial crisis. Thus, the management of the transport company could not speculate on the future. The swaps seemed beneficial to both the bank as well as the Metro do Porto, which were considered among the clientele base (Vallee et al. 1). They would enter into the swaps and further suit the requirements of both parties at the time when the bank intended to record profits from the underlying transactions. However, Metro do Porto would receive lower interest rates as compared to what they have been were previously paying.

Very Risky

The exotic swaps were financially very risky to Metro do Porto, especially in the case of future fluctuations in the swaps market.Primarily, the swaps indicated a probability of 72% which offered prospectivegains to Metro do Porto overtime. However, due to long term effects, the interest rate was bound to change in the future. The risk of interest rates breaching the upper barrier or lower barrier in the future was very high and would prolong for an extended period. The effects would be exaggerated by the market influence together with the buildup in the “snowball” nature of the exotic swaps. Santander Spain expressed concerns regarding the sale of”snowball” swaps to most of companies in Portugal because of the involved high risk. Eventually, Santander did not let a direct negotiation to characterize the transaction of these exotic swaps as it wereaccomplished by the bank officers in Portugal (Vallee et al. 1). Thus, the swaps were very risky in the future, especially due to market fluctuations although when they were entered the risk was considered as acceptable.

Both parties did not foresee the effects of a financial crisis. The rate of reference interests would continuously dropclose to zero and prolong for an unprecedented period. Besides, the swaps seemedexclusivelyimpacted by a financial crisis leading to a point where theexotic swaps “snowball” structures considerably amplified the effects of constant near-zero rates. Indeed, the effects on the almost zero-rates were worsen by the failures of”mitigating features”which compounded the fiscal crisis. When the companies entered into long-term swaps, Metro do Porto would have managed the debt through restructuring the swaps (Vallee et al. 1). However, efforts by Banco Santander to restructure the swaps immediately after the financial crisis have set in were unsuccessful. The major reason was that they were yet to determine whether it was in the interest of Metro do Porto’s to wait, terminate or restructure the swaps within the period, thus the delay.

WorkCited

Vallee, Boris, Patrick Augustin, and Philippe Rich. “Exotic Interest Rate Swaps: Snowballs in Portugal.” (2017).