The Mechanics of Interest Rate Swaps

Amazingly Presented By:Greg Mendonca

Outline

• Origins of interest rate swaps

• “Plain Vanilla” interest rate swaps

• Example of a plain vanilla swap

• Comparative advantage

• Other uses for swaps

Origins of Interest Rate Swaps

1981 Interest Rate Rise

Banks trying to protect against the rising short term interest rates

World Bank and IBM Origin

US Rates vs. German Rates vs. Swiss Rates

IBM swapping debt obligations with World Bank in order to lower interest for both World Bank and IBM

“Plain Vanilla” Swap

Two Basic Actions:

1. Firm A pays a fixed rate of interest to Firm B on a predetermined notional value

2. Firm B pays a floating rate of interest to Firm A on the same notional value

Netting of the payments amount

Fixed rate agreed upon, floating rate based on either US T-Bill or London Interbank Offered Rate (LIBOR) plus a base point premium

Example of Plain Vanilla Swap

• Banks– Lending long-term (fixed rate mortgages)

• Insurance Companies– Investment portfolio (floating rate bonds)

------------> <------------

Notional Amount

Interest Rates Down, Insurance Wins, YAY!

Example cont.

Interest Rates Decrease Interest Rates IncreaseFloating Rate Payer Gain LossFixed Rate Payer Loss Gain

Risk/Return Profile of Counterparties to and Interest Rate Swap

Theory of Comparative Advantage

• Some entities have a comparative advantage:– One entity may have an advantage in fixed rate

markets– One entity may have an advantage in floating rate

markets

• Using each entities comparative advantage they could enter an interest rate swap in order to leverage their advantage to another company and earn a spread

Comparative Advantage cont.

From Commercial Loan Portfolio = 10%From Interest Rate Swap = 6-Month T-bill rate + 155 b.p.Total = 11.55% + 6-Month T-bill rate

Annual Interest Rate Received

To CD Depositors = 6-Month T-bill rate + 40 b.p.On Interest Rate Swap = 10%Total = 10.4% + 6-Month T-bill rate

Annual Interest Rate Paid

To Be Received = 11.55% + 6-Month T-bill rateTo Be Paid = 10.4% + 6-Month T-bill rateSpread Income = 1.15% or 115 b.p.

Outcome

If the bank uses their comparative advantage on their commercial loan portfolio, they can earn a spread income from the swap

Other Uses For Swaps

• Reducing funding costs– Company looking to raise funds issues fixed rate 6

month papers and enters into swap to receive floating rate

• Asset/Liability management– Changing payments streams from fixed to variable

and vice versa

• Speculative positions– Enter into swap take a position gaining from either a

drop or rise in interest rates

Time To Say Goodbye…

Remember to keep your swaps under your pillow and I’ll visit you

at night!