Describe the credit risk exposure in a swap position. s� ˤH&0*�"� �l`�_ٚ���L ���6ˌl�>*�,�g'==����|ܗ�. different bases.
The table below provided the various rates at which all the five firms can borrow: $$ 0000026502 00000 n 0000005386 00000 n $$ For more accurate results, it is important to consider day count conventions. $$ \begin{array}{lcccc} \textbf{Time in Years} & \textbf{6-month LIBOR (% per year)} & \textbf{Floating amount paid (USD)} & \textbf{Fixed amount received (USD)} & \textbf{Net cashflow (USD)} \\ 0.0 & 3.00 & & & \\ 0.5 & 3.20 & 1500 & 2000 & +500 \\ 1.0 & 3.44 & 1600 & 2000 & +400 \\ 1.5 & 4.00 & 1720 & 2000 & +280 \\ 2.0 & 4.30 & 2000 & 2000 & –\\ 2.5 & 4.44 & 2150 & 2000 & -150 \\ 3.0 & 4.70 & 2220 & 2000 & -220 \end{array} $$.
0000007657 00000 n \end{array} 93 0 obj <>stream The pay floating, receive fixed party has a short position in the floating rate (since it’s an outflow) and a long position in the fixed-rate (since it’s an inflow). \text{Firm}& \text{Fixed rate} & \text{Floating rate} & \text{Fixed spread} & \text{Floating} & \text{Possible} \\ The above calculations are just approximations as they do not consider day counts. $$. When a comparative advantage exists, the implication is that the parties involved can reduce their borrowing costs by entering into a swap agreement. Assume two parties, A and B. The chief risk manager at the firm has advised that the firm convert this debt into a floating rate obligation by tapping into the interest rate swap market. Floating/Floating Rate Swap Asset Yield (LIBOR + 3/4% Bank T-bill + 1/2% <-----> LIBOR Counterparty CD LIBOR Funding (T-bill - 1/4%) (LIBOR - 1/4%) In a floating/floating rate swap, the bank raises funds in the T-bill rate market and promises to pay the counterparty a periodic interest based upon the LIBOR rate… \text{B} & 8\% & \text{LIBOR + 100bps} \\ \hline h�bbd``b`��@�� H0��b��$���~ ��� 0 Щ� 0000029130 00000 n \text{Firm X} & 4.5 & 1.0 & -0.5 & -1.5 & 1.0 \\ \hline To value this swap, we follow the below steps; $$\begin{align*} \text{Value in USD} &= 150(1.045^{-1})+150(1.045^{-2}+150(1.045^{-3}) = 412.3447\\ \text{Value in Euros}& = 100(1.035^{-1})+100(1.035^{-2}+100(1.035^{-3}) = 280.1637\\ \end{align*} $$. declines in the growth rate of the cashflows simply due to lower inflation offset part of the benefit of lower interest rates. %PDF-1.4 %���� September 22, 2019 in Financial Markets and Products, Part 1. The company will then have converted a 4% fixed interest rate into a 0.94% + LIBOR floating interest rate. Describe the comparative advantage argument for the existence of interest rate swaps and evaluate some of the criticisms of this argument. A swap dealer intertwines themselves between the parties taking a commission on the trade. In turn, the counterparty commits themselves to make payments based on either a floating rate or a fixed rate. It also assumes zero transaction costs even when an intermediary is involved in the swap (which is standard practice). Interest rate swaps can be used to transform assets into liabilities, or vice-versa, by converting fixed (floating) rates loans and liabilities into floating (fixed) rates. Assume the swap bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat. 0000008022 00000 n \begin{array}{|c|c|c|c|c|c|}
��Mj�u�D Similarly, the fixed rate will be expressed with day count conventions as shown below: $$ \frac{183}{360} × 4\% × 100,000 = 2,033.33 $$. %PDF-1.5 %���� Because the principals in a currency swap are in different currencies, they are exchanged at the inception of the swap. Therefore, \(A\) has an absolute advantage in both markets but a comparative advantage in the fixed market. Calculate the value of a plain vanilla interest rate swap from a sequence of forward rate agreements (FRAs). 0000002737 00000 n That could happen if each borrows in the market in which they have a comparative advantage, and then swapping into their preferred currencies for their liabilities.
The principal in an interest rate swap is known as a notional principal because it is not exchanged. The interest rate and currency swap are thereby ef-fectively combined. 3473 41 h�b```f``f`b``�f�e@ ^����)ݪ��p�C��| ���\?��a���5+D6���R� ��p���30�b��@�A�����c�4�ǀ�a_:Ę. Let’s look at an example of two firms, \(A\) and \(B\).
Party B, in return, agrees to pay party A interest at the six-month LIBOR (London Inter-Bank Offered Rate). A company borrows a bank USD 5,000 at a fixed interest rate of 4%, compounded quarterly. 0000008643 00000 n The fixed rate amount will be \(4\%×0.5×100,000= 2,000\). Assume that the 3-year bid and ask quotes are 3.06% and 3.09%, respectively. 0000005557 00000 n In case of default, the seller then pays the buyer the notional amount. 0000002313 00000 n However, the difference in borrowing rates for \(A\) and \(B\) is higher in the fixed market than in the floating market (200bps vs. 100bps).
If during this time, interest rates rise … Note: 183 was obtained by adding the total number of days between 1st January and 1st July, and the day count convention for LIBOR is actual/360. \text{Firm Y} & 7.0 & 4.0 & 2.0 & 1.5 & 0.5 \\ \hline In finance, an interest rate swap (IRS) is an interest rate derivative (IRD).It involves exchange of interest rates between two parties. 0000009314 00000 n {} & {} & 6-\text{month LIBOR +} \\ \hline Each party must append their signature on the confirmation to show their commitment to the agreement. Bring your Study Experience to New Heights with AnalystPrep, Access exam-style CFA practice questions (Levels I, II & III), Access 4,500 exam-style FRM practice questions (Part I & Part II), Access 3,000 actuarial exams practice questions (Exams P, FM and IFM). 0000013970 00000 n With the building blocks in place, it outlines the determinants of swap prices. 3473 0 obj <> endobj A problem with the comparative advantage argument is that it assumes the floating rates will remain in force in the long-term. Swaps can give rise to credit risk, especially when no collateral has been posted. 0000000016 00000 n 0000027097 00000 n
Interest for the USD leg \(= 0.03 × 5,000 = 150\). Party C is a company with LIBOR dollar liabilities and Swiss franc revenues i.e. If \(X\) wants to borrow \(£\), and \(Y\) wants to borrow \($\), the two may be able to able to save on their borrowing costs. Calculate the value of a currency swap based on two simultaneous bond positions. {} & {} & \text{LIBOR +} & {} & \text{spread} & \text{benefit} \\ \hline
\text{Steel} & 5.0 & 2.5 & {} & {} & {} \\ \hline SOA – Exam IFM (Investment and Financial Markets). \hline 0000006483 00000 n |�g�~��ݻպ"��w#�n�o��0���'ܽ뻟��>���H��۵�������X������5�\٧Vִ���0],��̥����a��\����_O�5a�����i��. J\����� �ԭ�e�|����$��!�A&'�� $|) �@����b�{s�e���R�8�lR���L`��Y1�Hg���2�f�f7��Y����~���V����Q{M��?q���>�d���)v�,ui,b�]��g��7����hg/b�B��B8W�� c�\���6DD�N�6/�?d�V7p��C�U�G�ݫ�fd������*Vӌ쩩�Yn�}UoUA�GIZD_�*��\8K��~�����!���T5�q� \hline 0000008270 00000 n It will pay a fixed rate of 3.09% under the terms of the contract. Problem #1 with interest rate argument: Inflation The most obvious problem with this analysis is that there is no context. $$ endstream endobj 82 0 obj <> endobj 83 0 obj <> endobj 84 0 obj <>stream Interest rate swaps and interest rate caps can be effective hedge tools to minimize interest rate risk. However, a party that has income based on the current level of interest rates, may prefer to have a variable interest rate. On a Friday, for example, d=3. 0000026750 00000 n \text{A} & 6\% & \text{LIBOR} \\ \hline
The first cash flow exchange is on 1st July of that year, and the floating rate exchanged will be: $$ \frac{183}{360} × 3\% × 100,000 = 1,525 $$. trailer It is important to see that 1,525 is 25 more than the approximate value shown in the table (1,500). The principal in an interest rate swap is known as a notional principal because it is not exchanged. Explain how a plain vanilla interest rate swap can be used to transform an asset or a liability and calculate the resulting cash flows. In a currency swap, there’s no netting of payments, again because the payments are not in the same currency.
\end{array} https://www.khanacademy.org/.../interest-rate-swaps-tut/v/interest-rate-swap-1 <<9BE4813FDED04A47BF5FFD78F75D82D2>]/Prev 712563/XRefStm 2313>> 0000003240 00000 n After completing this reading, you should be able to: An interest rate swap is an agreement to exchange one stream of interest payments for another, based on a specified principal amount, over a specified period of time. Suppose an individual purchases a 3% fixed-rate 30-year bond for $10,000. dealer’s pricing and sales con ventions, the relevant indices needed to determine pric ing, formulas for and examples of pricing, and a review of variables that have an affect on market and termination pricing of an existing swap. A loan with a variable interest rate adds a level of uncertainty (and potentially risk) to the loan that a borrower may want to avoid. %%EOF This bond pays $300 per year through maturity. 0000006105 00000 n Assume also that 1 Euro = 1.15 USD. Payments are exchanged every year for three years, and interest rates are annually compounded. The swap dealer effectively serves as an intermediary. Just like in other OTC instruments, parties to a swap do not interact one on one. Party A agrees to pay Party B a fixed rate of interest at 4% per annum, compounded semiannually, on a principal of USD 100,000.