the mechanics of interest rate swaps amazingly presented by: greg mendonca
Post on 21-Dec-2015
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TRANSCRIPT
Outline
• Origins of interest rate swaps
• “Plain Vanilla” interest rate swaps
• Example of a plain vanilla swap
• Comparative advantage
• Other uses for swaps
Origins of Interest Rate Swaps
1981 Interest Rate Rise
Banks trying to protect against the rising short term interest rates
World Bank and IBM Origin
US Rates vs. German Rates vs. Swiss Rates
IBM swapping debt obligations with World Bank in order to lower interest for both World Bank and IBM
“Plain Vanilla” Swap
Two Basic Actions:
1. Firm A pays a fixed rate of interest to Firm B on a predetermined notional value
2. Firm B pays a floating rate of interest to Firm A on the same notional value
Netting of the payments amount
Fixed rate agreed upon, floating rate based on either US T-Bill or London Interbank Offered Rate (LIBOR) plus a base point premium
Example of Plain Vanilla Swap
• Banks– Lending long-term (fixed rate mortgages)
• Insurance Companies– Investment portfolio (floating rate bonds)
------------> <------------
Notional Amount
Interest Rates Down, Insurance Wins, YAY!
Example cont.
Interest Rates Decrease Interest Rates IncreaseFloating Rate Payer Gain LossFixed Rate Payer Loss Gain
Risk/Return Profile of Counterparties to and Interest Rate Swap
Theory of Comparative Advantage
• Some entities have a comparative advantage:– One entity may have an advantage in fixed rate
markets– One entity may have an advantage in floating rate
markets
• Using each entities comparative advantage they could enter an interest rate swap in order to leverage their advantage to another company and earn a spread
Comparative Advantage cont.
From Commercial Loan Portfolio = 10%From Interest Rate Swap = 6-Month T-bill rate + 155 b.p.Total = 11.55% + 6-Month T-bill rate
Annual Interest Rate Received
To CD Depositors = 6-Month T-bill rate + 40 b.p.On Interest Rate Swap = 10%Total = 10.4% + 6-Month T-bill rate
Annual Interest Rate Paid
To Be Received = 11.55% + 6-Month T-bill rateTo Be Paid = 10.4% + 6-Month T-bill rateSpread Income = 1.15% or 115 b.p.
Outcome
If the bank uses their comparative advantage on their commercial loan portfolio, they can earn a spread income from the swap
Other Uses For Swaps
• Reducing funding costs– Company looking to raise funds issues fixed rate 6
month papers and enters into swap to receive floating rate
• Asset/Liability management– Changing payments streams from fixed to variable
and vice versa
• Speculative positions– Enter into swap take a position gaining from either a
drop or rise in interest rates