Question

Explain the concept of an interest rate swap. Find an example of a publicly traded firm that used an interest rate swap. Provide detailed analytics on how the swap was used and how it benefited both firms involved. You should include amounts, time frames, and actual rates.

Answer 1

Interest Rate swap : An interest rate swap is an agreement between two counterparties in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.

In 2016 around october Citigroup’s Trading desk made $300million by trading Interest Rate Swaps.

Example: Mr. X owns a $1,000,000 investment that pays him LIBOR( London inter bank offered rate)+ 1% every month. The payment for Mr. X keeps changing as the LIBOR keeps changing in the market. Now assume there is another guy Mr. Y who owns a $1,000,000 investment that pays him 2% every month. The payment received by him never changes as the interest rate assumed in the transaction if fixed in nature.

Now Mr. X decides that he doesn’t like this volatility and would rather have fixed interest payment, while Mr. Y decides to explore floating rate so that he has a chance of higher payments. This is when both of them enter into an interest rate swap contract. The terms of the contract states that Mr. X agrees to pay Mr. Y LIBOR + 1% every month for the notional principal amount $1,000,000. In the lieu of this payment, Mr. Y agrees to pay Mr. X 2% interest rate on the same principal notional amount.

SCENARIO 1: LIBOR STANDING AT 0.25% - Mr. X receives $30,900.00 from his investment at 3.09% (LIBOR standing at 2.09% and plus 1%). Mr. Y receives the fixed monthly payment of $20,000 at 2% fixed interest rate. Now, under the swap agreement, Mr. X owes $30,900.00 to Mr. Y, and Mr. Y owes $20,000 to Mr. X. The two transactions partially offset each other, the net transaction would lead Mr. Y to pay $10,900 to Mr. X.

So, what did the interest rate swap did to Mr. X and Mr. Y? The swap has allowed Mr. X guaranteed payment of $15,000 every month. If LIBOR is low, Mr. Y will owe him under the swap, however, if the LIBOR is high, he will owe Mr. Y. Either way, he will have the fixed monthly return of 1.5% during the tenure of the contract. It is very important to understand that under the interest rate swap arrangement, parties entering into the contract never exchange the principal amount.