Interest Rate Swaps

Question 1

What are ITS

Answer 1

Illiquid OTC derivative product

No clearing houses/ exchanges involved in transaction

Largest part of international derivative market

Contractual agreement between 2 counterparties who borrows capital (same amount) and then agree to swap interest rate streams

Both remain liable for capital borrowed

Both interest streams based on same notional amount over specific period

Maturity over agreed period/ established at start of contract and settled @ end

Set predetermined payment dates (fixed)

Off balance sheet transactions (no exchange of principal sum)

Derivative =the notional; rather than interest test rates based on the notional amount

Question 2

Categories of ITS

Answer 2

Fixed rate for floating rate (plain vanilla swap)

Floating rate for floating rate

Fixed rate for fixed rate

Question 3

Explain plain vanilla interest rate swap

Answer 3

One party agrees to swap with another party a fixed rate of interest based on a notional amount in exchange for a floating rate based on same notional amount

Floating rate based on index (LIBOR) whereas fixed rate based on difference index

Question 4

Users

Answer 4

Financial institutions/ investment or commercial banks (way of lending and must be able to clearly explain risks)

Non financial co’s (in unable to borrow large sums of capital & pay interest)

Local authorities

Insurance co’s (foreign investments)

Pension funds

*each user will employ difference strategies and achieve own objectives

Question 5

Uses

Answer 5

Hedgers;
Manage interest rate exposure, fixed and floating assets and commitments, obligations

Speculators;
Speculate on future interest rate movements (who expects IT will fall would obtain floating rate obligation and swap for fixed/ as floating rate fall speculators will pay lower floating rate in exchange for same fixed rate)

Opportunities for arbitrage due to diff credit ratings between parties

Question 6

How do parties control risks in ITS

Answer 6

Used to manage exposure to changes in interest rate

Banks make large revenue amounts from being involved in swap markets

Independent to swap there’s underlying obligation to pay interest (rationale from swap in the 1st place)

Question 7

What are the risks involved in ITS

Answer 7

Interest rate risks

• changes affect floating rate payer as rates linked to index (LIBOR)
• rates vary from original contract terms but obligation to pay still
• if LIBOR rises could cause anticipated profits to vanish or losses incurred
• if interest rates rise fixed rate payer benefits while floating rate payer loses out (vise versa)

Counterparty risk

• risk of default on obligation to pay interest
• risk is lower the higher the credit rating of the connterparty/ party making fixed payments considered less creditworthy than party making floating payments

Question 8

Example of ITS

Answer 8

Party A swaps fixed interest with party B for floating interest.

A has floating rate commitment - coupon swap
B has fixed rate commitment - swap rate

Both borrow £5m

A = 5% pa 
B = LIBOR + 25 points 

Swap

A= receiver (£5 x 5.75% = 287,500 pa (pays b))

B= payer (£5 x 5% = 250,000 pa (pays A))

Amounts netted A pays B difference = £37500

*participants involved in swap referred to from perspective of payment of fixed IT

Question 9

Who is receiver who is payer

Answer 9

Payer = party making fixed payments while receiving floating payments

Receiver = party making floating payments while receiving fixed payments