Int rate swap
- 1. Financial Derivatives (KMB FM05) Interest Rate Swap Prepared by : Taru Maheshwari Sr.Asstt.Prof. ABESEC AKTU (Lucknow)
- 2. Interest Rate Swap • An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.
- 4. Plain Vanilla • There are several types of plain vanilla swaps, including an interest rate swap, commodity swap, and a foreign currency swap. The term plain vanilla swap is most commonly used to describe an interest rate swap in which a floating interest rate is exchanged for a fixed rate or vice versa.. Both legs of the swap are denominated in the same currency, and interest payments are netted. The notional principal does not change during the life of the swap.
- 5. Basis Swap • Basis rate swaps are a form of floating for floating interest rate swaps. These types of swaps allow the exchange of variable interest rate payments that are based on two different interest rates.A basis rate swap (or basis swap) is a type of swap agreement in which two parties swap variable interest rates based on different money market reference rates. • For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate, but they borrow money based on the Treasury Bill rate.
- 6. Example • Calculate effective rate of Interest from the following if A requires floating interest loan and B requires fixed interest loan: A ltd B Ltd Fixed Rate-8% Fixed Rate-12% Floating-LIBOR+1% Floating-LIBOR+3%
- 7. Solution • Total Rate of Interest without swap A ltd - LIBOR+1% B ltd- 12 % so total is LIBOR+13% After Swap A ltd - 8% B ltd- LIBOR+ 3 % so total is LIBOR+11% Net Gain – 2% - 1% commission =1% Effective Rate for A - LIBOR+1% - .5 = LIBOR+.5 Effective Rate for B - 12% - .5 = 11.5%