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the basis swaps, the hedge swaps served a risk management
function for the banks. They were designed to replicate the
portfolio effects of partly financing the purchase of the
Citicorp Notes with a conventional amortizing loan, whose value
would not be affected by changes in LIBOR, rather than with the
highly volatile LIBOR Notes.15
The structured transactions were designed to be remunerative
for the dealer, Merrill Capital. Under the basis and hedge
swaps, the present value of the banks' payment obligations
exceeded the present value of Merrill Capital's obligations. In
this way, the swaps were expected to result in the transfer from
the banks to Merrill Capital of the 5/8 discount incurred by ACM
on the contingent payment sale. To the extent that the basis
swap continued beyond 3 months, Merrill Capital would return some
or all of the discount to the banks through the stepped up LIBOR
payments.
BOT and BFCE would not have participated in the hedge swaps
if they did not also perceive an opportunity to profit. Internal
bank documents confirm that those who negotiated the structured
15 The banks did not actually pay Merrill Capital the full
amount of the interest coupons they received from Citicorp, nor
did Merrill Capital pay them the full amounts payable to ACM
under the LIBOR notes. On each payment date amounts owed by each
counterparty to a swap were offset, and only the net payments
were made. The netting of payments is standard practice in the
swap market and was provided for in all of the swap agreements
discussed hereafter.
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