Question

Explain how a plain vanilla interest rate swap is constructed.

Analyse the comparative advantage argument for the popularity of swaps. Support your analysis with a numerical example.

Answer 1

Swap is a private agreement between two parties to exchange future cash flows from an agreed asset. In other words, it is a series of forward contracts with the agreement to exchange payments on specified date. (Plain vanilla) Interest Rate Swap Exchange of interest payment (example fixed vs. floating) on a notional principal at a pre-agreed date. Typically, net interest is paid by the party that owes it at the settlement date. The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate indexed to a reference rate (such as LIBOR or EURIBOR). By market convention, the counterparty paying the fixed rate is called the "payer" (while receiving the floating rate), and the counterparty receiving the fixed rate is called the "receiver" (while paying the floating rate). Comparative advantage If one of the two firms has an absolute advantage over another firm in borrowing and the difference in fixed rates at which the two firms can borrow is not the same as difference in the floating rates the two firms can borrow at, then the two firms can enter into a swap agreement involving an intermediary so as to get a combined benefit of interest rate reduction. If any bank’s liabilities are more sensitive to interest rates than its assets then it should subject the liabilities to fixed interest rate if a choice exists. So it makes sense to pay fixed and receive floating. Example: Assume Alpha and Beta can borrow fixed and floating as per table below: Firm Fixed rate Floating Alpha 4% LIBOR Beta 6% LIBOR + 100 bps By observation, Alpha has an advantage over Beta in borrowing. Differential fixed rate = 6% - 4% = 2% Differential floating rate = LIBOR + 100 bps - LIBOR = 100 bps = 1% Combined benefit to both the firms Alpha & Beta if they enter into swap is = Differential fixed rate - differential floating rate = 2% - 100 bps = 2% - 1% = 1% The swap can be entered through an intermediary (an investment bank) Alpha borrows at 4% and lends it to Beta at 4.5% through the investment bank. Beta borrows at floating LIBOR + 100 bps and lends it to Alpha at LIBOR Net borrowing rate for Alpha = 4% - 4.5% + LIBOR = LIBOR - 0.5% which is 0.5% lower than LIBOR at which it could have borrowed floating Net borrowing rate for Beta = 4.5% + LIBOR + 100bps - LIBOR = 5.5% which is 0.5% lower than 6% at which it could have borrowed fixed Thus both the firms benefit by 0.5% or 50 bps due to this swap This is the comparative advantage we are talking about. Another Example: Sundaram Corporation (“SC”) is currently paying floating rate = LIBOR + 2.50%, but wants to pay fixed rate. Bhargava Corporation (“BC”) is currently paying fixed rate = 9.50%, but wants to pay floating rate. Show how by entering into an interest rate swap, the net result is that each party can swap their existing obligation for their desired obligation. Solution:

Total payable by both the parties to banks = LIBOR + 2.50% + 9.50% = LIBOR + 12.00%. SC & BC should enter into an interest rate swap: SC pays fixed rate of 9.65% to BC and BC pays floating rate = LIBOR + 1.70% to SC

Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net. Net interest payment by SC to BC = max [9.65% - (LIBOR + 1.70%), 0] Net interest payment by BC to SC = max [LIBOR + 1.70% - 9.65%, 0] So one of the parties will make a net payment to the other depending upon who is net payable. Net interest payment by SC = LIBOR + 2.50% + 9.65% - (LIBOR + 1.70%) = 10.45% net Net interest payment by BC = LIBOR + 1.70% + 9.50% - 9.65% = LIBOR + 1.55% net Total payable by both the parties = 10.45% + LIBOR + 1.55% = LIBOR + 12.00% same as before but see how SC is now paying a fixed rate while BC is paying a floating rate, what they have desired. The fixed rate (9.65% in this example) is referred to as the swap rate. At the point of initiation of the swap, the swap is priced so that it has a net present value of zero.