Question

Design a Hypothetical Plan Vanilla Interest Rate Swap where there is a financial intermediary. Demonstrate how the swap has value to all parties (i.e., the fixed to floating, the floating to fixed and the financial intermediary). Determine the amount of benefit to each party in terms of annual interest rate savings, etc. Show the flow of funds at each interest payment date for all parties. Discuss the credit risk issues associated with such swaps. Indicate the risk should LIBOR increase and should LIBOR decrease. Discuss the criticisms against the comparative advantage argument.

I understand and have completed the interest rate swap but I am unsure how to answer the questions related to the swap.

Answer 1

The most common and simplest swap is a plain vanilla interest rate swap. In this swap, Party X agrees to pay Party Y a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party Y agrees to make payments based on a floating interest rate to Party X on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates.

For example, assume that Mr.A owns a $1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Mr.A receives changes.

Now assume that Ms.B owns a $1,000,000 investment that pays her 1.5% every month. The payment she receives never changes ie. It is fixed.

Mr.A decides that that he would rather lock in a constant payment and Ms.B decides that she'd rather take a chance on receiving higher payments. So they agree to enter into an interest rate swap contract.

Under the terms of their contract, Mr.A agrees to pay Ms.B LIBOR + 1% per month on a $1,000,000 principal amount (called the notional principal). Ms.B agrees to pay Mr.A 1.5% per month on the $1,000,000 notional amount. 1 case is depicted in the image attached herewith. Please refer to that for clarification.