Interest Rate Swaps

Magdalena Pavlova & Monika Schuster Lecture: Bond Analysis Lecturer: Prof. Dr. Schittenhelm

Agenda:
Definition of Swap and Interest Rate Swaps Definition of LIBOR, EURIBOR and example Types of Swaps Advantages of Interest Rate Swaps Risks characteristics of Interest Rate Swaps Summary

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Swap
A swap is an agreement between two parties to exchange (swap) payments at certain dates in the future.
As payments to B

Counterparty A
Bs payments to A

Counterparty B

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Interest rate swap

An interest rate swap is a contractual agreement between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. Especially corporates use SWAPs. Banks use it for interest risk hedging. Interest rates swaps are a way for financial bodies to exchange risk on the movement of interest rates Interest rate swaps are normally longer in their terms, generally for a period of one year or more.

Magdalena Pavlova & Monika Schuster

LIBOR and EURIBOR

The reference rates for interest rate swaps are LIBOR (London Interbank Offered Rate) and EURIBOR ( Euro Interbank Offered Rate) Euribor and LIBOR are comparable base rates. Euribor is the average interbank interest rate at which European banks are prepared to lend to one another. LIBOR is the average interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another. Just like Euribor, LIBOR comes in 15 different maturities. The main difference is that LIBOR rates come in 10 different currencies.

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LIBOR example
ABC Company and XYZ Company enter into one-year interest rate swap with a nominal value of $1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1%, since both parties believe that LIBOR will be roughly 4%. At the end of the year, ABC will pay XYZ $50,000. If the LIBOR rate is trading at 4.75%, XYZ then will have to pay ABC Company $57,500.

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LIBOR example (continued)

Therefore, the value of the swap to ABC and XYZ is the difference between what they receive and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a gain of $7,500, while XYZ realizes a loss of $7,500. Generally, only the net payment will be made. When XYZ pays $7,500 to ABC, both companies avoid the cost and complexities of each company paying the full $50,000 and $57,500.
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Types of swaps
Fixed-for-floating rate swap (plain vanilla swap or coupon swap) Floating-for-floating rate swap (basis swap) Fixed-for-fixed rate swap

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Plain vanilla interest swap

Company agrees to pay cash flows equal to interest at a predetermined fixed rate on a stated notional principal for a stated period and, in return, the Company receives interest at a floating rate on the same notional principal for the same period of time. Counterparty A is called the fixed rate payer or swap buyer Counterparty B is called the floating rate payer or swap seller
Fixed rate payments

Counterparty A
Floating rate payments

Counterparty B

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Basis swap
A contract between two parties where one party pays a floating rate of
interest on a notional amount using one index (e.g. 1-month LIBOR), and the other party pays a floating rate of interest on the same notional amount using a different index. Only the net payment amount is exchanged. A basis swap is used to help a company hedge against its basis risk.

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Fixed-for-fixed rate swap

An arrangement between two parties (known as counterparties) in which both parties pay a fixed interest rate that they could not otherwise obtain outside of a swap arrangement. This swap helps international companies benefit from lower interest rates available to domestic consumers and avoid currency conversion costs. The interest rate does not change over the life of the loan.

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Fixed-for-fixed rate swap example

An American firm can take out a loan in the United States at a 7% interest rate, but requires a loan in yen to finance an expansion project in Japan, where the interest rate is 10%. At the same time, a Japanese firm wishes to finance an expansion project in the U.S., but the interest rate is 12%, compared to the 9% interest rate in Japan. Each party can benefit from the other's interest rate through a fixed- forfixed currency swap. In this case, the U.S. firm can borrow U.S. dollars for 7%, then lend the funds to the Japanese firm at 7%. The Japanese firm can borrow Japanese yen at 9%, then lend the funds to the U.S. firm for the same amount.
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Advantages of Interest rate swaps

1) 2) Manage Interest Rate Risk Match Fund Assets and Liabilities

3)

Profit from Interest Rate Movements

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Risk Characteristics of Interest rate swap

Interest rate swaps involve three primary risks: 1) margin risk 2) rate risk 3) credit risk
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Summary
Interest rate swaps, a financial innovation in recent years, are based upon the principle of comparative advantage. An interest rate swap is a useful tool for active liability management and for hedging against interest rate risk. The purpose of this presentation is to provide a simple economic analysis of interest rate swaps. Alternative uses of and the appropriate evaluation procedure for interest rate swaps are also described. or interest rate swaps are described.

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Sources
http://www.treasurer.ca.gov/cdiac/publications/math.pdf http://www.investopedia.com/articles/optioninvestor/07/swaps.asp#axzz1dPX998Ps

http://www.ehow.com/how_5035920_value-interest-rate-swap.html
http://www.usatoday.com/money/economy/2008-09-28-4255348925_x.htm http://www.moneycrashers.com/interest-rate-swaps-explained-example-definition/ http://financial-dictionary.thefreedictionary.com/Swap http://www.wisegeek.com/what-is-a-notional-amount.htm
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Magdalena Pavlova & Monika Schuster