Presentation Bond Analysis.

8/3/2019 Presentation Bond Analysis.

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Interest Rate SwapsMagdalena Pavlova & Monika Schuster

Lecture: Bond Analysis

Lecturer: Prof. Dr. Schittenhelm


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Agenda:

Definition of Swap and Interest Rate Swaps Definition of LIBOR, EURIBOR and example

Types of Swaps

Advantages of Interest Rate Swaps

Risks characteristics of Interest Rate Swaps

Summary

Magdalena Pavlova & Monika Schuster


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Swap A swap is an agreement between two parties to exchange

(swap) payments at certain dates in the future.

Counterparty A Counterparty B

As payments to B

Bs payments to A



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Interest rate swap

An interest rate swap is a contractual agreement between two

counterparties under which each agrees to make periodic payment to theother for an agreed period of time based upon a notional amount of

principal.

Especially corporates use SWAPs. Banks use it for interest risk hedging.

Interest rates swaps are a way for financial bodies to exchange risk on

the movement of interest rates

Interest rate swaps are normally longer in their terms, generally for a

period of one year or more.



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LIBOR and EURIBOR

The reference rates for interest rate swaps are LIBOR(London InterbankOffered Rate) and EURIBOR ( Euro Interbank Offered Rate)

Euribor and LIBOR are comparable base rates. Euribor is the averageinterbank interest rate at which European banks are prepared to lend toone another.

LIBOR is the average interbank interest rate at which a selection of bankson the London money market are prepared to lend to one another.

Just like Euribor, LIBOR comes in 15 different maturities. The main

difference is that LIBOR rates come in 10 different currencies.

5Magdalena Pavlova & MonikaSchusterMagdalena Pavlova & Monika Schuster


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LIBOR example

ABC Company and XYZ Company enter into one-year interest rate swap

with a nominal value of $1 million.

ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of

LIBOR plus 1%, since both parties believe that LIBOR will be roughly 4%.

At the end of the year, ABC will pay XYZ $50,000. If the LIBOR rate is

trading at 4.75%, XYZ then will have to pay ABC Company $57,500.



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LIBOR example (continued)

Therefore, the value of the swap to ABC and XYZ is the difference

between what they receive and spend.

Since LIBOR ended up higher than both companies thought, ABC won out

with a gain of $7,500, while XYZ realizes a loss of $7,500.

Generally, only the net payment will be made. When XYZ pays $7,500 to

ABC, both companies avoid the cost and complexities of each company

paying the full $50,000 and $57,500.



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Types of swaps

Fixed-for-floating rate swap (plain vanilla swap orcoupon swap)

Floating-for-floating rate swap (basis swap)

Fixed-for-fixed rate swap

8Magdalena Pavlova & MonikaSchuster



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Plain vanilla interest swap

Company agrees to pay cash flows equal to interest at a

predetermined fixed rate on a stated notional principal for a stated

period and, in return, the Company receives interest at a floating rate onthe same notional principal for the same period of time.

Counterparty A is called the fixed rate payer or swap buyer

Counterparty B is called the floating rate payer or swap seller

Counterparty A Counterparty B

Fixedrate payments

Floating rate payments

9Magdalena Pavlova & Monika Schuster


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Basis swap

A contract between two parties where one party pays a floating rate of

interest on a notional amount using one index (e.g. 1-month LIBOR), andthe other party pays a floating rate of interest on the same notional amount

using a different index.

Only the net payment amount is exchanged.

A basis swap is used to help a company hedge against its basis risk.

-



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Fixed-for-fixed rate swap

An arrangement between two parties (known as counterparties) in which

both parties pay a fixed interest rate that they could not otherwise obtainoutside of a swap arrangement.

This swap helps international companies benefit from lower interest ratesavailable to domestic consumers and avoid currency conversion costs.

The interest rate does not change over the life of the loan.



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Fixed-for-fixed rate swap example

An American firm can take out a loan in the United States at a 7%

interest rate, but requires a loan in yen to finance an expansion project in

Japan, where the interest rate is 10%. At the same time, a Japanese firm wishes to finance an expansion project

in the U.S., but the interest rate is 12%, compared to the 9% interest rate in

Japan.

Each party can benefit from the other's interest rate through a fixed- for-

fixed currency swap. In this case, the U.S. firm can borrow U.S. dollars for7%, then lend the funds to the Japanese firm at 7%. The Japanese firm can

borrow Japanese yen at 9%, then lend the funds to the U.S. firm for the

same amount.



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Advantages of Interest rate swaps

1) Manage Interest Rate Risk

2) Match Fund Assets and Liabilities

3) Profit from Interest Rate Movements



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Summary

Interest rate swaps, a financial innovation in recent years, arebased upon the principle of comparative advantage. An interestrate swap is a useful tool for active liability management andfor hedging against interest rate risk. The purpose of thispresentation is to provide a simple economic analysis of

interest rate swaps. Alternative uses of and the appropriateevaluation procedure for interest rate swaps are also described.or interest rate swaps are described.



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Sources

http://www.treasurer.ca.gov/cdiac/publications/math.pdf

http://www.investopedia.com/articles/optioninvestor/07/swaps.asp#axzz1dPX998Ps

http://www.ehow.com/how_5035920_value-interest-rate-swap.html

http://www.usatoday.com/money/economy/2008-09-28-4255348925_x.htm

http://www.moneycrashers.com/interest-rate-swaps-explained-example-definition/

http://financial-dictionary.thefreedictionary.com/Swap

http://www.wisegeek.com/what-is-a-notional-amount.htm

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Presentation Bond Analysis.

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