Notes_11_finance_5108_08 - Notes 11 Interest Rate Swaps...

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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 transform either a liability or asset from fixed rate to variable rate or a variable
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This note was uploaded on 11/23/2009 for the course FIN 5180 taught by Professor Rader during the Fall '09 term at Temple.

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Notes_11_finance_5108_08 - Notes 11 Interest Rate Swaps...

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