The Mechanics of Interest Rate Swaps Xiaocheng Li 2nd June, 2013

Agenda What is In. Swap History of interest rate swaps How does In. Swap work Example of Interest swaps Comparative advantage Other uses for swaps

What is In. Swap Interest swaps are agreements to exchange a series of cash flows on periodic settlement dates over a certain time period.

History 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

Example of In. Rates Swap FIRM A ISSUE BOND ON floating rate FIRM B ISSUE BOND ON fixed rate bonds A B Notional Amount 8% FX 8.5% FL ------------> <------------

“In. Rates” Swap Two Basic Actions: Firm A pays a fixed rate of interest to Firm B on a predetermined notional value 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 In. Swap                                                                                                                                                                                                                                                                                                

Example of In. Swap Firm A----------------------> Firm B when LIBOR < 5.5% Firm A <---------------------> Firm B when LIBOR = 5.5% Firm A <----------------------- Firm B when LIBOR > 5.5%

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

Other Uses For Swaps Reducing funding costs Asset/Liability management 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