Notes 11
Interest Rate Swaps
Learning Objectives
1. Understand the basics of plain Vanilla interest rate swaps.
You should be able
to set up the swap.
2. Understand the ability of swaps to transform the liabilities of a firm
3. Be able to introduce a swap desk to the equation
4. Understand the comparative advantage argument for swaps and its criticisms
5. Understand the zero LIBOR/SWAP rate using bootstrapping
6. Obtain knowledge on the valuation of interest rate swaps and methodologies
7. Understand currency Swap and their structure
8. Understand the valuation of Currency swaps
9.
Obtain knowledge of the credit risk in the swap market
10 Variation on the plain vanilla swaps
Interest rate Swaps
Company
A
Company B
Plain Vanilla Interest
Rate Swap
Floating
Fixed
Company A
LIBOR + 1
10%
Company B
LIBOR + 2
12%
Pays 10%
Pays 11.5%
Pays
LIBOR + 2
Assets Variable
Rate
Asset Fixed Rate
Pays
10%
Gets 11.5%
Pays LIBOR + 2
Net
LIBOR + .5
Pays LIBOR + 2
Gets LIBOR +2
Pays 11.5%
Net
11..5%
Amount Swap is based on $100
million is the Notional Principal
A and B are counter parties
Term is 3 years Called the Tenor
Assuming Settlement is 6 months and Libor is 10%
A pays B (10 + 2)/(2)(100) X $100,000,000 = $6,000,000
B pays to A 11.5/(2)(100) X 100,000,000 = $5,750,000
Netting A pays to be $750,000
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The following table looks at what happens over the next 3 years as far as cash
flows go
In millions
Date
Libor
A to B
B to A
Net
Payment
1
10
6
5.75
0.25
2
12
7
5.75
1.25
3
8
5
5.75
0.75
4
9
5.5
5.75
0.25
5
13
7.5
5.75
1.75
6
14
8
5.75
2.25
The 100 million is called the notional principal and is the amount the swap is
based on.
As can be seen from the above figure the purpose of the swap is to transform the
variable rate liability of B into a fixed rate liability and to transform the variable
rate liability to a fixed rate liability.
Plain vanilla swaps could be used to
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 Fall '09
 Rader
 Finance, Derivatives, Interest, Interest Rate, Interest rate swap, variable rate

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