Interest Rate Swaps Flashcards
What is a “Plain Vanilla” interest rate swap ?
Company agrees to pay a fixed interest rate payment on a notional principal for a given number of years
What is a swap ??
A swap is an over-the-counter agreement between two parties to exchange cash flows at specified future times according to certain specified rules
What does LIBOR stand for
London Interbank Offered Rate
What are typical uses of an interest rate swap ?
Converting a liability from:
- Fixed rate to floating rate
- Floating rate to fixed rate
Converting an investment from:
- Fixed rate to floating rate
- Floating rate to fixed rate
What are market makers ?
-They are essentially swap dealers
-Unlikely that 2 companies will need to take opposite positions in exactly the same swap at exactly the same time
-They are prepared to enter swap without having an offsetting swap with another counter party
When transforming a liability, the companies net liability is
The LIBOR + N% - LIBOR + % paid to other company on same principal
When transforming a liability with a financial institution involved, the companies net liability is
The LIBOR + N% - LIBOR + % paid to other company on same principal
Then work out the financial institution’s profit which is %paid to financial institution - %paid from financial institution to other company
When transforming an asset, the companies net interest rate inflow is
Interest provided% + LIBOR - %paid on principal to other company
When transforming an asset with a financial institution involved, the companies net interest rate inflow is
Interest provided% + LIBOR - %paid on principal to other company
Then work out the financial institution’s profit which is %paid to financial institution - %paid from financial institution to other company
How do you find out the total gains from Interest rate swap ?
Difference in Fixed Rates - Difference in Floating Rates
What is the comparative advantage argument ?
When a companies have an advantage in floating-rate markets compared to fixed-rate markets
What is some criticism of the comparative advantage arguement
-Different periods between fixed and floating rates
-Floating rates are subject to regular reviews and may change
What is credit risk in terms of swaps
It is lower than what the magnitude of the notional principal would suggest
Credit Risk example
-Interest rates increases shortly after interest rate agreement
-Floating rate payer suffers an agreement and backs out
-Fixed-rate payer only suffers loss of difference between fixed and floating
-Default of floating-rate payer relieves the fixed rate payer from it’s obligation too
What is a forward rate agreement
A forward rate agreement (FRA) is an OTC agreement that a certain rate will apply to a certain principal (either for borrowing or lending) during a certain future time period
For a FRA:
*L: the principal underlying the contract
*The FRA period is between T1 and T2
*RFRA: the rate of interest agreed to in the FRA
*RFL: the forward LIBOR for the period T1 - T2
*r: the risk-free interest rate
What is the equation for the FRA
Vfra = L x (Rfl - Rfra) x (T2 -T1) x e^rT2
How to value an Interest Rate Swap
Can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond
What is the value of an interest rate swap for a fixed-rate payer ??
-Vswap = Bfl - Bfix
What is the value of an interest rate swap for a floating-rate payer ??
-Vswap = Bfix - Bfl
How do you value an interest rate swap in terms of FRA’s
Vfra = L x (Rfl - Rfra) x (T2 -T1) x e^rT2
Overnight index swaps
-Fixed rate for a period is exchanged for the geometric average of the overnight rates
-An OIS therefore allows overnight borrowing or lending to be swapped for borrowing or lending at a fixed rate.
-It bears the risk the counterparty (another bank) in the OIS arrangement will default
-To compensate for this risk, the LIBOR rate is generally higher than the OIS rate
