MORGAN STANLEY
P R O D U C T T R A I N I N G
Module VII:SWAPS
FOR INTERNAL USE ONLYNOT TO BE DISTRIBUTED EXTERNALLY
MORGAN STANLEY
PRODUCT TRAINING -FID ANALYST PROGRAMME AUGUST 2000
SWAPS
1
INTEREST RATE SWAPS
An interest rate swap is an agreement between two parties toexchange a fixed payment for a floating payment.
Example
Company A agrees to pay Company B 8% a year for 5 years on$10 million in return for B paying A 6-month LIBOR on the samesum.The interest rate swap arose in the early 1980s. Banks were happylending to some borrowers who were unable to raise fixed ratefunds through the bond market owing to investor aversion.However, banks were happier lending floating funds. It made sense,therefore for a company who wanted to borrow fixed funds, butwho could not conveniently do so, to find another company whowanted to borrow floating funds. The latter company would issuea fixed rate bond and the former would issue a floating rate note(or else borrow direct from its bankers), and the two companieswould agree to swap.
ABank BLendere.g. bank Lendere.g. bondholderFixedFixedFixedLIBORLIBOR LIBOR
MORGAN STANLEY
PRODUCT TRAINING -FID ANALYST PROGRAMME AUGUST 2000
SWAPS
2
Example
Company A wants fixed funds.Company B wants floating funds.A would borrow fixed at 8% and floating at 6-month LIBOR +½%.B would borrow fixed at 7% and floating at 6-month LIBOR flat.A issues an FRN at LIBOR + ½%. B issues a fixed rate bond at7%. A agrees to pay B 7.25% and B agrees to pay A 6-monthLIBOR flat.As net cost of funds: +(L + 0.5) - L + 7.25 = 7.75% (saving0.25%)Bs net cost of funds: +7% - 7.25% + L = LIBOR - 0.25%(saving 0.25%)The swap rate is thus 7.25% annual versus 6-month LIBOR.Because there is this differential between relative cost of funds indifferent markets, which is a form of arbitrage, both companiescan save money against their normal cost of funds. Note also thatthe total saving available, 0.50%, is equal to the difference betweenthe fixed rate differential and the floating rate differential. This savingscalculation is useful as it allows an instant determination of theamount available to be shared between the two companies.
AB
7¼%7% BondFRNLIBOR + ½%LIBOR
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