Interest Rate Swap
March 2011
Odie Pichappan
Odie Pichappan
Interest Rate Swap
1
Bird’s Eye View
 What is Swap?
 Different Types
 Benefits
 Swap Terminologies
 Comparative Advantage
 Simple Calculation with Example
 Trading Swap Spreads
 Graph
 Trading Swap Switch & Butterfly
 Buying and selling Swap Spreads
What is Swap?
 Swap is an agreement between two parties, called
Counterparties, who exchange future cash flows over a
period of time based on market conditions.
 Interest Rate Swaps
 Commodity Swap
 Currency Swaps and more
 Mortgage servicer would like to transform their fixed rate
assets to floating rate assets…
 Commodity producer wishes to fix his income and would
agree to pay the market price to a financial institution, in
return for receiving fixed payments for the commodity…
 Mitigate Price Risk
 Lower Progressive Tax
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Interest Rate Swap
3
Swap Terminologies
ForEx
$£¥€
Floating
to Fixed
Interest
Rate
Buyer
Seller
Payer
SM
Receiver
ME
Fixed to
Floating
Fixed
Payment
Buyer - Counterparty that receives floating/variable cash flow (Long Swap)
Payer - Counterparty that pays fixed rate.
Seller - Counterparty that is paying floating/variable cash flow (Short Swap)
Receiver - Counterparty that receives fixed rate.
Odie Pichappan
Interest Rate Swap
4
Swap Terminologies
• Notional principal – amount on which the periodic
payment of cash flow is calculated.
• Payment period – interest calculation period and cash
exchanged at the end of the period.
• Day count convention (Yield basis) – determines how
interest accrues over time period (Actual/360 float,
30/360 fixed).
• Rate fixing (Rate Reset) – normally done 2 days before
start of period.
• ISDA - International Swaps and Derivatives Association,
trade organization of participants in the market for overthe-counter derivatives.
• Tenor – Maturity of the swap in years.
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Interest Rate Swap
5
Comparative Advantage
• Apple Inc wants to borrow at floating rate and Boeing Co
wants to borrow at fixed rate, under following borrowing
rates. Counterparty
FLOATING RATE
FIXED RATE
APPLE INC
LIBOR + 1.11%
6.25%
BOEING CO
LIBOR + 2.34%
7.66%
Difference
1.23%
1.41%
• Apple has relative advantage in fixed market and Boeing
has relative advantage in floating market.
• The total arbitrage gain by entering into a swap deal would
be 1.41% - 1.23% = 0.18%
• Design a swap where the gain are equally shared between
the 2 companies and the swap dealer.
Odie Pichappan
Interest Rate Swap
6
Comparative Advantage Calculation
gained 6 bps
gained 6 bps
LIBOR
LIBOR
Boeing
Apple
Net 7.60%
Net L+1.05
Y = 5.26%
+L
-Y
- (L + 2.34)
-(7.66 - 0.06)
gained 6 bps
X = 5.20%
LIBOR + 2.34%
6.25%
- 6.25
-L
+X
-(L + 1.11 - 0.06)
Both counterparties gained 6 bps by borrowing in their
preferred market where they have comparative advantage.
Odie Pichappan
Interest Rate Swap
7
Swap Spreads
4
3.5
Treasury Yield
3
Swap Rate
Rates (%)
2.5
2
1.5
1
0.5
0
2
3
5
Sw ap Maturity (years)
7
10
Trading Swap Switch & Butterfly
swap
rate
swap
rate
Flattener
Steepener
Rec
2y
Black dotted line is initial
swap curve…
Pay
5y
Pay
5y
Rec
10y
swap
rate
Combination of top 2
curve trades makes
butterfly strategy…
Butterfly
Rec
2y
Odie Pichappan
Interest Rate Swap
2Pay
5y
Rec
10y
9
Trading Swap Spreads
Cash Flow Diagram
Coupon
Payments
3.42715
BOA
Swap Rate
3.54215
BOA Sells 50m 10y Swap Spreads at 11.50 bps to BNP
51m 10y notes at 101-21 = 3.54215
3.42715 Treasury Yield
0.115 Swap Spread
3.54215 Swap Rate
Sell
Repo Payments
Coupon
Payments
2.19138
Repo Payments
UBS
Pay
Swap Rate
2.39888
UBS Pays 100m 5y Swap Spread at 20.75bps to RBS
102m 5y notes at 99-22 = 2.39888
2.19138 Treasury Yield
0.2075 Swap Spread
2.39888 Swap Rate