Interest Rate SwapMarch 2011

Odie Pichappan

Odie Pichappan Interest Rate Swap 1

Bird’s Eye View

What is Swap? Different Types Benefits

Swap Terminologies Comparative Advantage

Simple Calculation with Example Trading Swap Spreads

Graph Trading Swap Switch & Butterfly Buying and selling Swap Spreads

Odie Pichappan Interest Rate Swap 3

What is Swap? Swap is an agreement between two parties, called

Counterparties, who exchange future cash flows over a period of time based on market conditions.

Interest Rate SwapsCommodity SwapCurrency Swaps and more

Mortgage servicer would like to transform their fixed rate assets to floating rate assets…

Commodity producer wishes to fix his income and would agree to pay the market price to a financial institution, in return for receiving fixed payments for the commodity…

Mitigate Price RiskLower Progressive Tax

3

BuyerME

Payer

SellerSM

Receiver

Buyer - Counterparty that receives floating/variable cash flow (Long Swap)Payer - Counterparty that pays fixed rate.

Seller - Counterparty that is paying floating/variable cash flow (Short Swap)Receiver - Counterparty that receives fixed rate.

Fixed to FloatingFloating

to Fixed

ForEx$ £ ¥ €

Interest Rate

Odie Pichappan 4Interest Rate Swap

Swap Terminologies

Fixed Payment

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Swap Terminologies

• Notional principal – amount on which the periodic payment of cash flow is calculated.

• Payment period – interest calculation period and cash exchanged at the end of the period.

• Day count convention (Yield basis) – determines how interest accrues over time period (Actual/360 float, 30/360 fixed).

• Rate fixing (Rate Reset) – normally done 2 days before start of period.

• ISDA - International Swaps and Derivatives Association, trade organization of participants in the market for over-the-counter derivatives.

• Tenor – Maturity of the swap in years.

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Odie Pichappan Interest Rate Swap 6

Comparative Advantage

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• Apple Inc wants to borrow at floating rate and Boeing Co wants to borrow at fixed rate, under following borrowing rates.

• Apple has relative advantage in fixed market and Boeing has relative advantage in floating market.

• The total arbitrage gain by entering into a swap deal would be 1.41% - 1.23% = 0.18%

• Design a swap where the gain are equally shared between the 2 companies and the swap dealer.

Counterparty FLOATING RATE FIXED RATE

APPLE INC LIBOR + 1.11% 6.25%

BOEING CO LIBOR + 2.34% 7.66%

Difference 1.23% 1.41%

Odie Pichappan Interest Rate Swap 7

Comparative Advantage Calculation

7

BoeingNet 7.60%

AppleNet L+1.05

6.25%LIBOR + 2.34%

LIBORLIBOR

5.26% 5.20%

gained 6 bps gained 6 bps gained 6 bps

Both counterparties gained 6 bps by borrowing in their preferred market where they have comparative advantage.

- 6.25- L+ X

-(L + 1.11 - 0.06)

+ L- Y

- (L + 2.34)-(7.66 - 0.06)

Y = X =

0

0.5

1

1.5

2

2.5

3

3.5

4

2 3 5 7 10

Swap Maturity (years)

Rat

es (

%)

Treasury Yield

Swap Rate

Swap Spreads

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Trading Swap Switch & Butterfly

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Black dotted line is initial swap curve…

Combination of top 2 curve trades makes butterfly strategy…

swaprate

Steepener

Rec Pay2y 5y

swaprate

Butterfly

Rec 2Pay Rec2y 5y 10y

swaprate

Flattener

Pay Rec5y 10y

Trading Swap Spreads

BOA

Coupon Payments 3.42715

Swap Rate3.54215

UBSCoupon Payments 2.19138

Swap Rate

2.39888Pay

Sell

Repo Payments

Repo Payments

Cash Flow Diagram

BOA Sells 50m 10y Swap Spreads at 11.50 bps to BNP51m 10y notes at 101-21 = 3.54215

3.42715 Treasury Yield0.115 Swap Spread

3.54215 Swap Rate

UBS Pays 100m 5y Swap Spread at 20.75bps to RBS102m 5y notes at 99-22 = 2.39888

2.19138 Treasury Yield0.2075 Swap Spread

2.39888 Swap Rate