Question

1. A commercial real estate investor receives fixed rents each month and makes mortgage payments based on a variable interest rate. Describe a swap the investor can enter into which will hedge their exposure to changing interest rates.

Answer 1

An interest rate swap is an agreement between two parties and they exchange the future interest rate payments with each another. The interest rate swaps are derivative contract . One of the most common interest rate swaps is known as Vanila swaps, which exchages the fixed rate payments for floating rate of payment based on LIBOR ( London Inter-Bank Offered Rate). These sort of swaps allows the investor to hedge the chance in change of future interest rate.

Interest rate Swap - fixed to floating

For example, A company A borrows some amount of cash say $ one million form lender 1. The company want to pay LIBOR + 2% to the lender and this company is paying a variable interest rate for every pery. Consider for period 1 if LIBOR is at 2% then the company wants to pay 4% to the lender in that period.

consider other company B borrows $ one million at a fixed rate of interest of 5% from lender 2. This company wants to pay about $ 50,000 in each period. Here the company A dont like the variability that happens to LIBOR and also the company B thinks that they're paying far more interest rate in each period. So, during this situation these two companies can swap the interest rates.

Through this swap, one party get the chance of protection from the rate of interest rate while the opposite party gets the potential profits from the floating rate.