Swap p.

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ECN4141 Financial Economics

Swap – agreement between two parties, called counterparties, to exchange a stream of cash flows over a fixed time frame in the future.  Highly customized private contract  Little government regulation Plain vanilla swap – basic interest rate or currency swap Interest rate swap (IRS)  Plain vanilla IRS - one party agrees to pay a sequence of fixed-rate interest payment and receive a sequence of floating rate interest payment  Pay fixed payment – swap buyer  Pay floating rate payment – swap seller  Tenor - time period over which the periodic interest payment will be made  Notional principal – amount used as a basis for computation of net payment to be made by counterparties  The floating rate interest payments are determined in advance and paid in arrears

This has eliminated interest rate 2 .000 3 7.Swap p. Party B will make payment to party A based on the LIBOR.75% of 1 million (the notional principal) or $87.500 each year to party B.000 87.  To avoid this risk.2 of 7 ECN4141 Financial Economics Example: Party A has agreed to pay 8.0 90.500 -12.500 -2.  The following diagram shows that the FI pays out LIBOR+1% on its deposit.500 Remarks A to B A to B B to A Converting a Floating Rate Obligation to a Fixed Rate Obligation  Consider a Financial Institution (FI) that accepts deposits and lends those funds out in the form of long-term loan.5 85. FI can enters into swap agreement with Party B on the pay-fixed side. Deposits are floating-rate liabilities and loans are fixed-rate assets.0 75. FI pays a fixed rate of 8% (equivalent to rate on loan) to party B and in exchange receives payment based on LIBOR.5 1 7.000 87.500 2 9.500 +2. Year LIBOR B pays A A pays B Difference 0 8.000 87. The FI can be left at risk should rates on deposit increases.

3 . but also becomes a party to the transaction.Swap p.3 of 7 ECN4141 Financial Economics exposure and locked in a positive cash flow of 100 basis point FI Fixed:8% Fixed:8% LIBOR +2% Party B Borrower LIBOR +1% Depositor  Swap may be arranged through intermediaries such as swap dealer or swap broker. They not only perform the function of a broker.

000 $1.000 To FI LIBOR+2% LIBOR+2% LIBOR+2% From B LIBOR+2.000 $1.1%.1%. To B $80. LIBOR+2.000 4 .000 $80. Fixed:8% LIBOR+2.1%.4 of 7 ECN4141 Financial Economics  The following diagram show the transaction involving broker FI Fixed:8% Broker Fixed:8% Party B LIBOR+2%.000 $80.000 $80.000 Broker’s Cash Flows = (LIBOR+2.LIBOR+2%) x 1 million Year 1 2 3 Net Cash Flows $1.1%.000 $80.1% . Borrower LIBOR +1% Depositor Cash Flows based on $1 million notional principal: Year 1 2 3 From FI $80.Swap p. LIBOR+2.

Upon maturity. Exchange equal initial principal amount of two different currencies at the spot exchange rate at the start of the agreement 2. Party A B US Dollar Rate 9% 8% UK Pound Rate 6% 7%  Party A has an advantage over Party B in the UK market but wants to hold US dollar 5 . but want to hold a different currency  Parties exchange equivalent amount denominated in different currencies  Interest payment (fixed or floating) are made by each party on the currency it receives  Three-step process: 1.Swap p. Pay fixed or floating rate payments over the term of the swap 3.5 of 7 ECN4141 Financial Economics Currency Swap (CS)  A party holds one currency. reswap the principal amount at the predetermined exchange rate Example: The following table shows the comparative advantages in borrowing rates enjoyed by party A and B.

50=£1.6 of 7 ECN4141 Financial Economics  Party B has an advantage over Party A in the US market but wants to hold UK pound  Party A borrows £10 million and Party B borrows $15 million  At the current spot rate of $1. the amounts are swapped. The following diagram shows the exchange of notional principal at the inception of swap agreement Party A £10 m $15 m Party B £10 m $15 m 6 .Swap p.

$1.5% £650.Swap p.000 $1.7 of 7 ECN4141 Financial Economics UK Bank US Bank The following diagram illustrates annual interest payments based on the rate agreed by both parties – 8.275 m @8.5% £600.2 m Party A Party B UK Bank US Bank 7 .5% UK rate.000 @6.5% US interest rate and 6.

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