Chapter 14 Interest rate and currency swap

# Chapter 14 Interest rate and currency swap - Master Your...

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Master Your Career Growth Chapter 14 Interest rate and currency swap

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Definition of swap In a swap, two counterparties agree to a contractual arrangement wherein they will exchange cash flows at periodic intervals. There are two types of interest rate swaps. Single currency interest rate swap “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps . Cross-currency interest rate swap This is often called a currency swap ; fixed for fixed rate debt service in two (or more) currencies.
The Swap Bank Swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer. As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap and then later lay off the risk, or match it with a counterparty. Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs. They also make a market in “plain vanilla” swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

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Interest Rate Swap Quotations Euro-€ £ Sterling Swiss franc U.S. \$ Bid Ask Bid Ask Bid Ask Bid Ask 1 year 0.32 0.36 0.51 0.54 0.06 0.12 0.32 0.35 2 year 0.44 0.48 0.68 0.72 0.11 0.19 0.42 0.46 3 year 0.59 0.63 0.81 0.85 0.20 0.28 0.63 0.66 4 year 0.77 0.81 0.97 1.02 0.34 0.42 0.89 0.92 5 year 0.95 0.99 1.15 1.20 0.49 0.57 1.17 1.20 6 year 1.14 1.18 1.35 1.40 0.66 0.74 1.45 1.48 7 year 1.30 1.34 1.55 1.60 0.83 0.91 1.69 1.72 8 year 1.46 1.50 1.74 1.79 0.98 1.06 1.91 1.94 9 year 1.60 1.64 1.92 1.97 1.11 1.19 2.09 2.12 10 year 1.74 1.78 2.08 2.13 1.21 1.29 2.25 2.28
Swap Quotations 1.74–1.78 means the swap bank will pay fixed-rate euro payments at 1.74% against receiving USD LIBOR or it will receive fixed-rate euro payments at 1.78% against paying dollar USD LIBOR. While most swaps are quoted against “flat” dollar LIBOR, “off-market” swaps are available where one party pays LIBOR plus or minus some number. Swap Bank Firm A Firm B €1.74% €1.78% USD LIBOR USD LIBOR

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Example of an Interest Rate Swap Consider Firms A and B; each firm wants to borrow \$40 million for three years. Firm A wants to finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate. A has good credit and can borrow at LIBOR. Firm B wants to finance an interest-rate-insensitive asset and thus wants to borrow at a fixed rate. B has less-than-perfect credit and can borrow fixed at 5.5%. The swap bank quotes a three-year swap as 5.1—5.2 (against dollar LIBOR). Fixed Floating A 5% LIBOR B 5.50% LIBOR + .20%
Example of an Interest Rate Swap Firm A 5.10% LIBOR Bank X Swap Bank If Firm A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of 5.1 —5.2, they can convert their fixed rate 5% debt into a floating rate debt at LIBOR – 0.10%.

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