interest rate swap introduction
TRANSCRIPT
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Odie PichappanInterest Rate Swap*Interest Rate SwapSwap is an agreement between two parties, called Counterparties, who exchange future cash flows over a period of time based on marketInterest Rate SwapsCommodity SwapCurrency Swaps and more*A 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
Interest Rate Swap
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Odie PichappanInterest Rate Swap*BuyerParty-APayerSellerParty-BReceiverLong Swap (Buyer)Counterparty that receives variable/floating cash flow
Short Swap (Seller)Counterparty that is paying variable/floating cash flowPayer counterparty that pays fixed rate.Receiver counterparty that receives fixed rate.Fixed to FloatingFloating to FixedSwap Terminology
Interest Rate Swap
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Odie PichappanInterest Rate Swap*Swap TerminologyDay count convention (Yield basis) determines how interest accrues over time period (Actual/360 float, 30/360 fixed).ISDA - International Swaps and Derivatives Association, Inc.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.Rate fixing normally done 2 days before start of period.Tenor Maturity of the swap*
Interest Rate Swap
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Odie PichappanInterest Rate Swap*Comparative Advantage*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.
CounterpartyFIXED RATEFLOATING RATEAPPLE INC6.25%LIBOR + 1.11%BOEING CO7.66%LIBOR + 2.34%Difference1.41%1.23%
Interest Rate Swap
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Odie PichappanInterest Rate Swap*Comparative Advantage Calculation*BoeingNet 7.60%AppleNet L+1.056.25%LIBOR + 2.34% LIBORLIBOR5.26%5.20%gained 6 bpsgained 6 bpsgained 6 bpsBoth counterparties gained 6 bps by borrowing in their preferred market where they have comparative advantage.
Interest Rate Swap
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Odie PichappanInterest Rate Swap*Counterparty Report*
Interest Rate Swap