Rate Swaps
What is an interest rate swap?
An agreement to exchange interest payments based on a notional principal.
What type of loan does Jimmy have?
Fixed-rate loan.
What is the fixed annual payment on a $1,000,000 loan at 7%?
$70,000
What is the amount used to calculate swap payments but never exchanged?
The notional principal.
What type of loan does Guillermo have?
Floating-rate loan.
What is the floating payment if LIBOR is 4% on a $1,000,000 notional?
$40,000
Who benefits when interest rates fall?
The floating-rate payer.
Who is better off when interest rates fall?
Guillermo
What is the net payment if the fixed leg is $70,000 and the floating leg is $40,000?
$30,000
How do you calculate the fixed leg payment in a rate swap?
Notional × fixed rate.
What do Jimmy and Guillermo do to improve their situation?
They swap interest payments.
Who pays net if LIBOR is below the fixed swap rate?
The fixed-rate payer pays.
What is the primary reason firms use interest rate swaps?
Hedging interest rate risk.
Why are both willing to enter the swap?
Opposite expectations about interest rates.
Who has an advantage when a swap is first created?
Neither party.