Lecture 6: Interest Rate Swaps and Currenncy Swaps Flashcards
What is an interest rate swap?
An agreement between two parties where one stream of future interest payments is exchanged for another. Most commonly the exchange is between an floating interest rate and a fixed one.
*only the net swap interest payment is made.
Define the following terms; pay-fixed party, recieved-fixed party, nominal amount?
Pay-fixed party: the party that pays the fixed interest rate.
Pay-recieved party: party that pays the floating interest rate.
Nominal amount: the principal of the lone.
What is the value of a new interest rate swap? Does the value change over time?
A new interest rate swap shoucl have a value equal to zero (in other words it shoul be in equilibrium).
As a swap decays the value will usually not be zero (i.e. interest rates may have changed(.
What determines the value of an interest rate swap?
The NPV of the cashflows of the underlying swap.
Net Swap Value = PV of Fixed - PV of Floating
*same interest/discount rate is used for both fixed and floating when calculating the NSV. Repayments with fixed (i.e. coupons) maintain their original value while the floating changes so that PV=principal.
What uses do interest rate swaps have as financial instruments?
They are useful to speculators and hedgers. They are valued at zero at initiation. This means that hedgers/speculators can hedge/speculate their positions without any initial cost.
What are the effects of an interest rate swap?
An interest rate swap has the effect of:
- Converting ME from a fixed-rate borrower to a floating-rate borrower.
- Converting YOU from a floating-rate borrower to a fixed-rate borrower.
*Banks and other financial institutions frequently enter into swaps to achieve this.
How might an interest rate swap reduce borrowing costs?
Reduced borrowing costs are achieved through creating an arbitrage, utilizing the differennce between the borrowing costs of two entities.
Why might borrowing rates for one entity be different to another with regards to both fixed and floating rates?
Supposed the floating-rate loan is from a domestic source bu the ficed-rate load is from a foreign one.
- One entity may be well known in the domestic market but has run up against domestic lender limits but due to its good credit rating foreign lenders are keen to lend fixed-rate funds to it but are less willing to lend to a lower-rated entitiy (thus a disparity in interest rates).
What is a currency swap?
The exchange of interest rates and sometimes principal in one currency for the same in another (i.e. it is ther difference between borrowing inn currency X and borrowing in currency Y for two borrowers.
What are the three basic types of currency swaps?
*Floating-for-Floating swaps are the most common.
- Fixed-for-Fixed
- Floating-for-Floating
- Fixed-for-Floating
What do currency swaps fundamentally do?
- Act as an instrument to faclitate hedging and speculating.
- To reduce borrowing costs
