1. Interest Rate and Currency Swaps

2. Interest Rate Swaps(A) 1. An Interest Rate Swap is a derivative. That is, it is derived from various money market and bond market instruments. It is not a direct source of funding. 2. Originally Interest Rate Swaps were developed to allow different borrowers to arbitrage different markets to get below target borrowing costs. (Example: Tektronix and Wells Fargo Bank)

3. Interest Rate Swaps(B) 3. An Interest Rate Swap allows one counterparty to receive a certain type of interest payment. And to pay a different type of interest payment. Both the payment and the receipt are in the same currency. 4. The most common Interest Rate Swap has one counterparty receiving 3 or 6 month LIBOR and paying a fixed rate for the tenor of the swap. (Tenors can be as long as 30 years).

4. Interest Rate Swaps(C) 5. The interest payments are based on a notional amount and only the net amount is paid or received. 6. As a derivative it is off balance sheet, while the underlying investment or borrowing is on balance sheet. 7. These swaps are used to convert a borrowing from fixed rate to floating or to manage interest rate risk.

5. Interest Rate Swaps(D) 1. Initially these transactions were done a matched basis. But with the advent of desktop computing power and the development of a variety of interest rate futures contracts, banks could warehouse any mismatches and two way quotes became common. 2. Banks that quote prices for interest rate swaps are called Swap Banks.

6. Swap Banks(A) 1. Swap Banks provide its clients with two way quotes. For example a quote of 2.15% - 2.20% for five years against 6 month LIBOR means the Swap Bank will pay 2.15% and receive 6 month LIBOR or receive 2.20% and pay 6 month LIBOR. 2. Thus if a client wanted to receive fixed it would receive 2.15% and pay the 6 month LIBO rate.

7. Swap Banks(B) 1. The Swap Bank acts as a counterparty to the transaction to provide a higher degree of credit safety 2. The Swap Bank also manages any mismatch in principal amortization schedules.

8. Currency Swaps 1. Currency Swaps are similar to Interest Rate Swaps but are in different currencies. 2. Since the currencies are different the principal payments are also paid and received. 3. For example, a corporation may want to pay floating rate dollars and receive fixed yen. The fixed yen may offset the payments on a yen based loan. The net effect is to change the loan from fixed yen to floating dollars.