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Unformatted text preview: 1 Swaps and Interest rate Derivatives P’ O Tuitional BBA International Financial Management 2 Interest Rate Swaps • Interest rate swap is an agreement between two parties to exchange U.S. dollar interest payments for a specific maturity on an agreed notional amount. • No principal ever changes hands. • Maturities range from less than a year to more than 15 years; however, most transactions fall within a 2-year to 10 year period. • The two main types are: – Coupon swaps Î One pays a Fixed rate and the other side pays a floating rate. – Basis swaps Î Two parties exchange floating interest payment based on different reference rate. • London Interbank Offered Rate (LIBOR) Î the most important reference rate in swap. 3 The Classic Swap Transaction • Both A and B require $100 million for a 5- year period. • Company A – would like to borrow at a fixed rate. – BBB-rated • Company B – prefer to borrow at a floating rate. – AAA-rated 0.5% 1.5% Difference 6-month LIBOR 7.0 % B : AAA – rated 6-month LIBOR + 0.5% 8.5% A : BBB - rated Floating-Rate Available Fixed-Rate Available Borrow- It is obvious that there is an anomaly between the two market: One judges that the difference in credit quality (AAA vs BBB) is worth 150 basis points; the other worth 50 basis points 4 • One basis point = 0.01% • To begin, – Company A take out $100 ml, at LIBOR + 50 basis points....
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- Spring '10
- Derivative, Interest rate swap, Basis Points