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

2. 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

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

4. 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

5. 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
> <

6. “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

7. Example of In. Swap
                                                                                                                                                                                                                                                                                               

8. 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%

9. 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

10. 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