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INTEREST RATE SWAPS

In terms of swaps, the market offers different opportunities for the hedging of future interest rate changes. Some of them are pure interest rate transactions but some of them are currency transaction or a mix of interest rate and currency.

Interest rate swaps are defined as the agreements between two parties to exchange interest payments on an agreed national amount for a particular maturity. The important point is that it is a notional amount, so the principal is not exchanged. The exchange of interest payments may be;

  1. Coupon swap: the parties of the transaction exchange fixed or floating rate coupons.
  2. Basis swap: the parties exchange coupons based upon e.g. LIBOR for coupons based upon e.g. 90-day treasury bills.

Swaps can be useful for locking in a fall in the interest rate. Interest rate swaps are basically used as a long-term instrument for periods more than one year. It is similar to forward rate agreements (FRAs) but like a series of FRAs, one for each payment date.

Table 17 involves five examples. These transactions can be summarised as follows;

  1. Firm 1 obtains through swap a US dollar loan while firm 2 obtains a CHF loan.
  2. Firm 1 obtains through swap a US dollar loan while firm 2 obtains a CHF loan.
  3. Firm 1 obtains a floating interest loan with the same currency while firm 2 obtains a fixed interest loan.
  4. Firm 1 borrows at LIBOR rate and swaps to obtain loan at US commercial paper rate while firm 2 borrows at US commercial paper rate and swaps to obtain loan at LIBOR rate.
  5. Firm 1 obtains floating rate US dollar loan through swap after borrowing in local market at fixed CHF interest while firm 2 obtains fixed rate CHF dollar loan through swap after borrowing in local market at floating US dollar loan.

Major Kinds of Interest Rate Swaps

Firm 1 borrows at

Firm 2 borrows at

Currency denomination

Currency swaps

1. Fixed interest (CHF)

2. Floating interest (CHF)

 

Fixed interest ($)

Floating interest ($)

 

Different

Different

Interest rate swaps

3. Fixed interest

4. Floating interest

 

Floating interest

Floating interest

 

Same

Same

Currency and interest rate swaps

5. Fixed interest(CHF)

 

Floating interest($)

 

Different

Source: Oxelheim and Wihlborg (1987)

The most used swap is the third one which one party pays a floating rate and the other party pays a fixed rate. Although about 75% of swaps are indexed to LIBOR, other typical floating rate indices are commercial paper funds rate, the prime rate and the T-bill rate.

The benefit of cost saving can be illustrated by the following example for the most popular fixed-floating interest rate swap:

Direct Funding

 

Credit Rating

 

Company A

 

Company B

Interest Differential

Direct Funding Availability-

Fixed Rate Funds

 

8% p.a.

 

9.50% p.a.

 

1.50% p.a.

Floating Rate Funds

6 month

LIBOR+¼%

6 month

LIBOR+¾%

 

0.50% p.a.

Company A raises Fixed Rate Funds

(8% p.a.)

 

 

Company B raises Floating Rate Funds

 

(6 month

LIBOR+¾)

 

Source: Greenacre (1992)

Company B must make floating rate funds available to Company A at a cheaper rate than that at which Company A could borrow in its own name, which is LIBOR+¼%. Therefore, in the swap Company B must make the floating rate funds available to Company A at LIBOR and must continue, itself, to pay the mark-up of ¾% p.a. This makes the effective cost of Company B’s fixed rate funds 9% p.a. i.e. 8.25% plus 0.75%.

Swaps Structure

 

Company A

Company B

Company A “Lends” to Company B-Fixed Rate

8.25% p.a.

(8.25% p.a.)

Company B “Lends” to Company A-Floating Rate

(LIBOR)

LIBOR

Net Funding Cost Company A (Floating) X

LIBOR-¼%

 

Company B (Fixed) X

 

9% p.a. (8.25%+¾%)

Direct Funding Cost Y

LIBOR+¼%

9.50

Comparison- Saving (Y-X)

0.50% p.a.

0.50% p.a.

Source: Greenacre (1992)

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