Occasionally, it involves an exchange of one stream of floating rate interest payments for another. The principal features of an interest rate swap are : • It effectively translates a floating rate borrowing into a fixed rate borrowing and vice versa. The net interest differential is paid or received, as the case may be. • There is no exchange of principal repayment obligations. • It is structured as a separate contract distinct from the underlying loan agreement. • It is applicable to new as well as existing borrowings. • It is treated as an off-the-balance sheet transaction.
X Y Floating rate borrowing Fixed rate borrowing LIBOR + 0.25% 10.5% LIBOR + 0.25% 10.5% INTEREST RATE SWAPS
CURRENCY SWAPS In a currency swap both the principal and interest in one currency are swapped for principal and interest in another currency. On maturity, the principal amounts are swapped back. Thus, a currency swap involves (i) an exchange of principal amounts today, (ii) an exchange of interest payments during the currency of the loans, and (iii) a re-exchange of principal amounts at the time of maturity. For example, if party A raises yens by issuing 5 percent yen bonds in the Japanese market and party B raises dollars by issuing 12 percent dollar bonds in the US market, a currency swap between them may be represented diagramatically as shown in Exhibit
DEFAULT SWAP • CREDIT DERIVATIVE TO PROTECT AGAINST DEFAULT RISK • COMPANY P AGREES TO PAY A FIXED AMOUNT ANNUALLY TO COMPANY Q, AS LONG AS C, A DEBTOR OF COMPANY P DOES NOT DEFAULT. IN RETURN, COMPANY Q PROMISES TO COMPENSATE COMPANY P, SHOULD C DEFAULT.
REASONS FOR SWAPS • Spread compression • Market segmentation • Market saturation • Difference in financial norms
Spread Compression Fixed Floating A 9% LIBOR B 11% LIBOR + 0.5% A interested on Floating Rate B interested on Fixed Rate
A B 9% Fixed Rate LIBOR + 0.5% 10.5% 10% LIBOR Spread Compression A: LIBOR + 9% -10% = LIBOR - 1% B: LIBOR + 0.5% + 10% - LIBOR = 10.5%
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- Fall '19