Topic 12: Interest Rate Swaps Flashcards
What is an interest rate swap?
Agreement between two parties to exchange periodic interest payments
- One party agrees to make fixed-rate interest payments to the second party in exchange for floating-rate payments.
What is base rate?
Base rate is the same as floating rate.
is an interest rate that can fluctuate over time. It is usually tied to a benchmark rate, such as LIBOR or SOFR
What is fixed rate?
The fixed rate is an interest rate swap that is constant over the life of the swap agreement.
The party paying the fixed rate makes consistent, predictable payments, regardless of any changes in the market.
What does it mean when the bank debits you the difference?
It means the company owes the bank money
What does it mean when the bank credits you the difference?
It means that the bank owes the company money.
What are the uses of interest rate swaps?
- To get around market constraints.
- Asset Liability management
What is the notional principal amount?
The amount is fixed, but the amount will not be transferred over.
No physical exchange of principal, only interest payments are exchanged
What is the price of the swap?
The fixed rate in an interest rate swap is often referred to as the “price” of the swap
- It determines what the fixed-rate payer will pay over the life of the swap.
Bid rate Vs Offer rate : Bank POV
Bid rate: The quoting bank only wants to pay a fixed rate at 5.2% in exchange for receiving floating rate payments.
(How much is the bank willing to take on the fixed interest payment, in exchange for giving away their floating interest payment to you)
Offer rate: The quoting bank wants to receive a fixed rate at 5.3% for paying a floating rate to the company.
(remember, banks want to “limit” their exposure & risk too, so they will be more conservative when it comes to paying an unpredictable amount, they might “charge” more.
What is comparative advantage?
Companies usually have different credit ratings and this will affect the interest rates that they have to pay when borrowing.
Some companies have to pay lesser interest for the loan.
Example of Comparative Advantage.
(Note, since topic of swaps, both company have comparative advantage.)
Company A obviously is a better credit risk than B and is able to borrow at cheaper rates for both fixed and floating rates compared to B.
(A’s relative advantage (or comparative advantage) is greater when it borrows at a fixed rate (1.20% lower than B compared to 0.70% when it borrows at a floating rate).
In contrast, B has to pay more than A for both fixed & floating rate borrowing, but their disadvantage is smaller when they borrow at a floating rate.
(B is said to have a comparative advantage (or you can say less disadvantaged) in floating rate borrowing.
What is Direct Borrowing from Market?
The ‘Direct Borrowing from Market” refers to the amount that has to be paid, if the company had borrowed from the market directly. (no need to enter swap)
What is net cost of funds?
Amount the company has to pay - receive
How to calculate Credit Arbitrage opportunity?
You simply have to find the difference in the “fixed” interest rates for both company & the difference in the “floating” interest rates in both companies, and then minus them off.
Who is the Fixed Rate Payer?
Person who took up the fixed interest but wants floating rate.
(received fixed from counterparty & pays floating rate to counterparty>)
