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Interest Rate SwapsMagdalena Pavlova & Monika Schuster
Lecture: Bond Analysis
Lecturer: Prof. Dr. Schittenhelm
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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.
Counterparty A Counterparty B
As payments to B
Bs payments to A
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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 theother 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.
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LIBOR and EURIBOR
The reference rates for interest rate swaps are LIBOR(London InterbankOffered Rate) and EURIBOR ( Euro Interbank Offered Rate)
Euribor and LIBOR are comparable base rates. Euribor is the averageinterbank interest rate at which European banks are prepared to lend toone another.
LIBOR is the average interbank interest rate at which a selection of bankson 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 orcoupon 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 onthe 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
Counterparty A Counterparty B
Fixedrate payments
Floating rate payments
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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), andthe 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 obtainoutside of a swap arrangement.
This swap helps international companies benefit from lower interest ratesavailable 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- for-
fixed currency swap. In this case, the U.S. firm can borrow U.S. dollars for7%, 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) Manage Interest Rate Risk
2) Match Fund Assets and Liabilities
3) Profit from Interest Rate Movements
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Summary
Interest rate swaps, a financial innovation in recent years, arebased upon the principle of comparative advantage. An interestrate swap is a useful tool for active liability management andfor hedging against interest rate risk. The purpose of thispresentation is to provide a simple economic analysis of
interest rate swaps. Alternative uses of and the appropriateevaluation 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
16Magdalena Pavlova & Monika Schuster
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