FIN 645: International Financial
Management
Lecture 5
Currency & Interest Rate Swaps
Lecture Outline
• Types of Swaps
• Size of the Swap Market
• The Swap Bank
• Interest Rate Swaps
• Currency Swaps
Lecture Outline (continued)
• Swap Market Quotations
• Variations of Basic Currency and
Interest Rate Swaps
• Risks of Interest Rate and Currency
Swaps
• Swap Market Efficiency
• Concluding Points About Swaps
Definitions
• In a swap, two counterparties agree to a
contractual arrangement wherein they
agree to exchange cash flows at periodic
intervals.
• There are two types of interest rate
swaps:
– Single currency interest rate swap
• “Plain vanilla” fixed-for-floating swaps are often just
called interest rate swaps.
– Cross-Currency interest rate swap
• This is often called a currency swap; fixed for fixed
rate debt service in two (or more) currencies.
Size of the Swap Market
• In 2007, the total amount of interest rate
swaps outstanding was $ 271.9
trillion($36,262 billion in 1998) and
outstanding Currency swaps$12
trillion($2253 billion in 1998)
• The most popular currencies are:
–
–
–
–
U.S.$ (34%)
¥ (23%)
€ (21%)
£ (6%)
The Swap Bank
• A swap bank is a generic term to describe
a financial institution that facilitates swaps
between counterparties.
• The swap bank can serve as either a
broker or a dealer.
– As a broker, the swap bank matches
counterparties but does not assume any of the
risks of the swap.
– As a dealer, the swap bank stands ready to
accept either side of a currency swap, and
then later lay off their risk, or match it with a
counterparty.
Interest Rate Swap in Project Finance
Transactions
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–
–
–
–
–
–
–
–
Definition of Project Finance
Three Approaches to Structured Finance
Types of Interest Rate
What is Interest Rate Risk?
What is Interest Rate Swap?
Types of Swaps
Advantages of Swap
Pricing of an Interest Rate Swap
Other Derivatives Used in Project Finance Transactions
Interest Rate Swap in Project Finance
Transactions
Definition of Project Finance
“The raising of funds to finance a standalone capital intensive project in which the
providers of the funds look primarily to the
cash flow from the project as the source of
(a) repayment of their loans, and (b) return
on their equity invested in the project”
Interest Rate Swap in Project Finance Transactions
Three Approaches to Structured Finance
Structured Finance
Project Finance
Acquisition
Finance
Securitization
Interest Rate Swap in Project Finance
Transactions
Types of Interest Rate
•
•
Fixed rate
– 10% on a 5-year bond
Floating/variable rate
– LIBOR, certificate of deposit, repo rate, average weighted
deposit rate (AWDR) of scheduled banks, call money rate,
etc.
What is Interest Rate Risk?
•
The uncertainty that over the life of the
loan, interest rate may move adversely,
thereby, causing a huge interest burden
for the project
Interest Rate Swap in Project Finance
Transactions
Interest Rate Swap in Project Finance
Transactions
Interest Rate Swap in Project Finance
Transactions
Important Concepts
•
Notional principal (the amount used as the basis for
computations of net payments to be made by swap
counter parties)
•
Tenor and payment dates
•
Fixed leg
•
Variable leg
•
Day counting convention
•
Payment netting
•
Counter party: buyer and seller
Interest Rate Swap in Project Finance
Transactions
Day Counting Conventions
Number of days
between two
payment dates
Number of days
in a year

X
Annual interest rate X Notional principal
3 types of day counting conventions are:
 actual/365
 actual/360
 30/360
Interest Rate Swap in Project Finance Transactions
Payment Netting
It is a market convention that the exchange of interest
payments between two parties is executed through
payment netting.
If fixed rate is lower than floating rate,the
residual goes to fixed rate payer.
Floating
Rate
Fixed Rate
If the fixed rate is higher than the floating
rate ,the res idual goes to fl oating r ate
payer.
Interest Rate Swap in Project Finance
Transactions
Basic Structure
BA: fixed
interest rate
Party “A"
$ 150
million
loan
Fixed
Interes
t Rate
Bank
AB: variable
interest rate
Swap would be
based on notional
principal of $100
million
Party “B"
$ 100
million
loan
Variable
Interest
Rate
Bank
Interest Rate Swap in Project Finance
Transactions
An Example
•
Party A agrees to pay 8.75% on $100 million to Party B. Party B agrees
to make floating rate payments to Party A in return. However, the actual
payment will vary with LIBOR.
Year
LIBOR
Party B Pays Party A
(Floating Rate)
Party A Pays
Party B (Fixed
Rate)
0
8.5%
1
LIBOR1 = ?
LIBOR0 X 1,000,000
=0.085 X 100,000,000
=8,500,000
8,750,000
2
LIBOR2 = ?
LIBOR1 X 100,000,000
875,0000
3
LIBOR3 = ?
LIBOR2 X 100,000,000
875,0000
4
LIBOR4 = ?
LIBOR3 X 100,000,000
8750000
5
N/A
LIBOR4 X 100,000,000
8750000
Net
payment
made is
$250,000
Interest Rate Swap in Project Finance
Transactions
Types of Swaps
–
–
–
–
–
Plain vanilla swaps,
Amortizing swaps,
Accreting swaps,
Roller coaster swaps,
Basis rate swaps, etc.
Interest Rate Swap in Project Finance Transactions
Types of Swaps: Plain vanilla swaps
–
–
–
–
–
–
Floating and fixed payments are regular, e.g.
every six months
Term of the swap is a whole number of years, e.g.
1, 2, 3, 10 years
One party makes fixed rate payments, the other
variable rate payments
Notional principal remains constant throughout
the life of the swaps
The fixed rate remains constant throughout the
life of the swaps
Suitable for loans with Principal repayment at the
end of loan life
Interest Rate Swap in Project Finance Transactions
Types of Swaps: Accreting swaps
Used when notional principal increases over time
Typical during the construction period
Principal Outstanding
•
•
25
20
15
10
5
0
1st
Semi
2nd
Semi
3rd
Semi
4th
Semi
5th
Semi
Construction Period
6th
Semi
Interest Rate Swap in Project Finance
Transactions
Types of Swaps: Amortizing swaps
•
Used when a loan has scheduled repayments of principal
over its term, rather than a bullet repayment structure
Notional principal decreases over time
Principal Outstanding
•
25
20
15
10
5
0
1st
Semi
2nd
Semi
3rd
Semi
4th
Semi
5th
Semi
Repayment Period
6th
Semi
Interest Rate Swap in Project Finance
Transactions
Types of Swaps: Roller coaster swaps
•
Accommodates the characteristics of both amortizing and
accreting swaps
Typical for large infrastructure projects
Principal Outstanding
•
25
20
15
10
5
0
1st
Semi
2nd
Semi
3rd
Semi
Construction Period
4th
Semi
5th
Semi
6th
Semi
Repayment Period
Interest Rate Swap in Project Finance
Transactions
Types of Swaps: Other swaps
Seasonal swap:
An interest rate swap in which the principal alternates between zero and the
notional amount (which can change or stay constant). The principal amount of
the swap is designed to hedge the seasonal borrowing needs of a company.
Off-market swap:
In this type of swap, a premium is built into the swap price to fund the
purchase of options or to allow for the restructuring of a hedge portfolio. Offmarket swaps are generally used to restructure or cancel old swap/hedge
deals: essentially, they simulate a refinancing pack-age
Interest Rate Swap in Project Finance
Transactions
Advantages of Swaps
•
•
•
•
•
•
•
•
•
Theory of comparative advantage applies i.e. entity should borrow at a
rate (fixed/floating) in which it has a comparative advantage.
Suppose X and Y are two companies.
X’s borrowing situations (in fixed and floating rate) are as follows:
Bank (Floating)
Bond (Fixed)
LIBOR + 0.35%
UST+0.70%
Y’s borrowing situations (in fixed and floating rate) are as follows:
Bank (Floating)
Bond (Fixed)
LIBOR + 1.5%
UST+3.50%
X has absolute advantage on both bank (floating) and bond (fixed)
loans.
However, Y has comparative advantage on bank (floating) loans.
Note this, for bank loan credit/quality spread of X vs. Y is
1.15%; while for bond it is 2.8%.
Hence, Y should borrow at floating rate (from Bank) while X should at
fixed rate (from bond market) and swap among themselves and
collectively realize total savings of 1.65% (2.8% minus 1.15%), known
as quality spread differential.
However, how this 1.65% will be shared depends on relative bargaining
power. In the illustration that follows, we see that X keeps 1.45% while
Y retains 0.2%.
Interest Rate Swap in Project Finance Transactions
Advantages of Swaps…cont’d
• Assuming LIBOR and UST are 6% and 8.5% respectively,
X
Y
Bank (Floating)
7.5%(6% + 1.5%)
Bond (Fixed)
9.2% (8.5% + 0.7%)
Assuming X & Y enter into a swap for a fixed rate of 10.3% (Y pays
fixed rate to X in exchange of LIBOR).
• Position of X, therefore is as follows:
Pays fixed rate on bond
9.2% p.a.
Receives from Y
(10.3%)
Pays LIBOR to Y
6.0%
Total payments
4.9% p.a.
Please note it is less than 1.45% of floating rate of LIBOR+0.35%.
• Position of Y, therefore is as follows:
Pays variable rate on bank loan
7.5% p.a.
Receives from X
(6.0%)
Pays fixed rate to X
10.3%
Total payments
11.8% p.a.
Please note it is less than 0.2% of fixed rate of UST+3.5%.
The QSD
• The Quality Spread Differential represents
the potential gains from the swap that can
be shared between the counterparties and
the swap bank.
• There is no reason to presume that the
gains will be shared equally.
• Less credit-worthy entity will probably
would have gotten less of the QSD, in
order to compensate the swap bank for
the default risk.
Interest Rate Swap in Project Finance Transactions
Floating Leg
PV
of
Floating
Leg =
$20
mill
Floating Leg
PV
of
Floating
Leg =
$20
mill
Floating Leg
PV
of
Floating
Leg =
$20
mill
Pricing of Swaps…cont’d.
g
>
g
<
PV
of
Fixed
Leg =
$18
mill
PV
of
Fixed
Leg =
$22
mill
7%
7%
7%
7%
Fixed Leg
9%
9%
9%
9%
Fixed Leg
Price of the Swap
=
PV
of
Fixed
Leg =
$20
mill
8%
8%
8%
Fixed Leg
8%
Interest Rate Swap in Project Finance Transactions
Pricing of Swaps









Illustration: A $105 million roller coaster swap
Loan amount: $105 million variable-rate loan.
Tenor: 5 years.
Grace period: 21/2 years.
Construction period: 2 years; during when interest on loan
is rolled up and capitalized.
Loan drawdown: 4 equal semi-annual drawdowns; first one
commencing at financial closing; while the rest three while
facility is being constructed.
Repayment profile: 6 level principal; semi-annual.
Repayment starts: First repayment commences on six
months after construction completion.
Problem: Find an equivalent fixed rate based on the same
notional principal with same drawdown profile.
Interest Rate Swap in Project Finance Transactions
Pricing of Swaps…cont’d.
• Swap Pricing [Shows Calculations]
Interest Rate Swap in Project Finance
Transactions
Other Derivatives Used in Project Finance Transactions
–
–
–
Interest rate cap
Interest rate floor
Interest rate collar
Interest Rate Swap in Project Finance Transactions
Interest Rate Cap
• An interest-rate cap is a derivative that protects the holder from rises in short-term
interest rates by making a payment to the holder when an underlying interest rate (the
"index" or "reference" interest rate) exceeds a specified strike rate (the "cap rate").
• Caps are purchased for a premium and typically have expirations between 1 and 7
years. They may make payments to the holder on a monthly, quarterly or semiannual
basis, with the period generally set equal to the maturity of the index interest rate.
• Each period, the payment is determined by comparing the current level of the index
interest rate with the cap rate. If the index rate exceeds the cap rate, the payment is
based upon the difference between the two rates, the length of the period, and the
contract's notional amount. Otherwise, no payment is made for that period. If a payment
is due on a USD Libor cap, it is calculated as
Class Exercise
• Payments made under a hypothetical
interest rate scenario by a 3-year
USD 200MM notional cap linked to 6month USD Libor with strike rate of
7.5%. Values for the index rate are
6.25%, 7.75%, 7.00%, 8.50%,
8.00%, and 6.25%.
Interest Rate Swap in Project Finance Transactions
Interest Rate Cap…an example
For example, a 3-year, USD 200MM notional cap with 6-month Libor as its index rate,
struck at 7.5%. The exhibit shows what the cap's payments would be under a
hypothetical interest rate scenario.
Payments made under a hypothetical interest rate scenario by a 3-year USD 200MM
notional cap linked to 6-month USD Libor with strike rate of 7.5%. Values for the index
rate are 6.25%, 7.75%, 7.00%, 8.50%, 8.00%, and 6.25%. These result in payments of
USD 0MM, USD .25MM, USD 0MM, USD 1MM, USD .5MM, and USD 0MM.
Interest Rate Swap in Project Finance Transactions
Interest Rate Floor
• Interest rate floors compare to interest rate caps are derivatives that protect the
holder from declines in short-term interest rates by making a payment to the holder
when an underlying interest rate (the "index" or "reference" interest rate) falls below a
specified strike rate (the "floor rate").
• Floors are purchased for a premium and typically have maturities between 1 and 7
years. They may make payments to the holder on a monthly, quarterly or semiannual
basis, with the period generally set equal to the maturity of the index interest rate.
• Each period, the payment is determined by comparing the current level of the index
interest rate with the floor rate. If the index rate is below the floor rate, the payment is
based upon the difference between the two rates, the length of the period, and the
contract's notional amount. Otherwise, no payment is made for that period. In US
markets, if a payment is due on a USD Libor floor, it is calculated as
An Example of a Currency Swap
• Suppose a U.S. MNC wants to finance
expansion of its German Subsidiary, the
cost is € 40,000,000
• Current exchange rate is $0.90/€1,
• The MNC could borrow $36,000,000 in the
U.S. where they are well known and
exchange for dollars for Euro.
– By issuing 5-year bonds at 8%
– This will give them exchange rate risk: financing
a Euro project with dollars.
An Example of a Currency Swap
• They could borrow € 40,000,000 in the
international bond market, but pay a lot
since they are not as well known abroad.
– The US firm could borrow 5-year fixed interest
rate of 7 percent; The current normal borrowing
rate for a well-known firm of equivalent credit
worthiness is 6 percent.
• A German MNC of equivalent
creditworthiness has a US subsidiary in
need of $36,000,000 to finance capital
expenditure with an economic life of five
years.
An Example of a Currency Swap
• The German parent could raise € 40,000,000 at a
fixed interest rate of 6 percent and convert the
fund into US dollars to finance the expenditure.
– Transaction exposure is created. If Euro appreciates the US
subsidiary might have difficulty to meet the debt service.
• The German parent could also issue Eurodollar
bonds (or Yankee bond in the US capital market),
say at a fixed rate of 9 percent, as it is not well
known.
• A swap bank could arrange a currency swap,
instruct each parent firm to raise funds in its
national capital market. Then the principal would be
exchanged through the swap bank.
An Example of a Currency Swap
• Annually, the German subsidiary would remit to its
US parent € 2,400,000 in interest(6 percent of €
40,000,000) to be passed through the swap bank
to the German MNC to meet Euro debt Service.
• The US subsidiary would remit to its German parent
$2,880,000 in interest(8 percent of $ 36,000,000)
to be passed through the swap bank to the US MNC
to meet dollar debt Service.
• At the debt retirement date, the subsidiaries would
remit the principal sums to their respective parents
through the swap bank to pay off the bond issues
in the national capital markets.
Benefits of a Currency Swap
• At inception, the principal sums are exchanged at the
current exchange rate of $0.90/ € 1= $36,000,000/ €
40,000,000.
• Each year prior to debt retirement, the swap agreement
calls for counterparties to exchange $2,880,000 of
interest on US dollar debt for € 2,400,000 of interest on
Euro debt; this is a contractual exchange rate of
$0.8333/ € 1.
• At the maturity date, a final exchange, including the last
interest payment and the re-exchange of the principal
sum would take place; $38,880,000 for € 42,400,000.
The contractual exchange rate at year 5 is thus
$0.9170/ € 1.
• Clearly, the swap locks in foreign exchange rates for
each counterparty to meet its debt service obligations
over the term of the swap.
US Dollar Euro Currency
Swap
German
capital market@6%
``US capital market
@8%
6%
8%
US MNC
€@6%
Swap Bank
$@8%
$@8%
=
=
Euro-denominated
Eurobond market7%
€@6%
German
MNC
Original Principal Exchange
Debt Service
Re-exchange of principal
Eurodollar
Eurobond market @9%
Risks of Interest Rate
and Currency Swaps
• Interest Rate Risk
– Interest rates might move against the swap
bank after it has only gotten half of a swap on
the books, or if it has an unhedged position.
• Basis Risk
– If the floating rates of the two counterparties
are not pegged to the same index.
• Exchange rate Risk
– Exchange rate might move against the swap
bank.
Risks of Interest Rate
and Currency Swaps (continued)
• Credit Risk
– This is the major risk faced by a swap dealer—
the risk that a counter party will default on its
end of the swap.
• Mismatch Risk
– It’s hard to find a counterparty that wants to
borrow the right amount of money for the right
amount of time.
• Sovereign Risk
– The risk that a country will impose exchange
rate restrictions that will interfere with
performance on the swap.
Swap Market Efficiency
• Swaps offer market completeness and
that has accounted for their existence and
growth.
• Swaps assist in tailoring financing to the
type desired by a particular borrower.
Since not all types of debt instruments are
available to all types of borrowers, both
counterparties can benefit (as well as the
swap dealer) through financing that is
more suitable for their asset maturity
structures.
An Example of a Currency
Swap
• If they can find a British MNC with a
mirror-image financing need they
may both benefit from a swap.
• If the exchange rate is S0($/£) =
$1.60/£, the U.S. firm needs to find
a British firm wanting to finance
dollar borrowing in the amount of
$16,000,000.
An Example of a Currency
Swap
Consider two firms A and B: firm A is a
U.S.–based multinational and firm B is a
U.K.–based multinational.
Both firms wish to finance a project in each
other’s country of the same size. Their
borrowing opportunities are given in the
table below.
$
£
Company A
8.0%
11.6%
Company B
10.0% 12.0%
An Example of a Currency
Swap
Swap
Bank
$9.4%
$8%
£12
%
£11%
$8%
Company
A
$
£
Company A
8.0%
11.6%
Company B
10.0% 12.0%
Company £12
%
B
An Example of a Currency
Swap
Swap
Bank
$9.4%
$8%
£11%
Company
A
A’s net position is to borrow at £11%
$8%
£12
%
$
£
Company A
8.0%
11.6%
Company B
10.0% 12.0%
A saves £.6%
Company £12
%
B
An Example of a Currency
Swap
Swap
Bank
$9.4%
$8%
£12
%
£11%
$8%
Company
A
Company £12
%
B
B’s net position is to borrow at $9.4%
$
£
Company A
8.0%
11.6%
Company B
10.0% 12.0%
B saves $.6%
An Example of a Currency
Swap
The swap bank makes
money too:
Swap
Bank
$8%
$8%
Company
A
1.4% of $16 million
financed with 1% of £10
million per year for 5
years.
£12
£11%
%
At S0($/£) = $1.60/£,
that is a gain of
$124,000 per year for 5
years.
$
£
Company A
Company B
$9.4%
Company £12
%
B
The swap bank
faces exchange
8.0% 11.6% rate risk, but
10.0% 12.0% maybe they can
lay it off in
another swap.
Comparative Advantage
as the Basis for Swaps
A is the more credit-worthy of the two firms.
A pays 2% less to borrow in dollars than B
A pays .4% less to borrow in pounds than B:
$
£
Company A
8.0%
11.6%
Company B
10.0% 12.0%
A has a comparative advantage in borrowing in dollars.
B has a comparative advantage in borrowing in pounds.
Comparative Advantage
as the Basis for Swaps
B has a comparative advantage in borrowing in £.
B pays 2% more to borrow in dollars than A
$
£
Company A
8.0%
11.6%
Company B
10.0% 12.0%
B pays only .4% more to borrow in pounds than A:
Comparative Advantage
as the Basis for Swaps
A has a comparative advantage in
borrowing in dollars.
B has a comparative advantage in
borrowing in pounds.
If they borrow according to their
comparative advantage and then swap,
there will be gains for both parties.
Swap Market Quotations
• Swap banks will tailor the terms of interest rate
and currency swaps to customers’ needs
• They also make a market in “plain vanilla” swaps
and provide quotes for these. Since the swap
banks are dealers for these swaps, there is a bidask spread.
• For example, 6.60 — 6.85 means the swap bank
will pay fixed-rate DM payments at 6.60%
against receiving dollar LIBOR or it will receive
fixed-rate DM payments at 6.85% against
receiving dollar LIBOR.
Variations of Basic Currency
and Interest Rate Swaps
• Currency Swaps
–
–
–
–
fixed for fixed
fixed for floating
floating for floating
amortizing
• Interest Rate Swaps
– zero-for floating
– floating for floating
• For a swap to be possible, a QSD must
exist. Beyond that, creativity is the only
limit.
Pricing a Swap
• A swap is a derivative security so it
can be priced in terms of the
underlying assets:
• How to:
– Plain vanilla fixed for floating swap gets
valued just like a bond.
– Currency swap gets valued just like a
nest of currency futures.
Concluding Remarks
• The growth of the swap market has
been astounding.
• Swaps are off-the-books
transactions.
• Swaps have become an important
source of revenue and risk for banks
An Example of an Interest
Rate Swap
• Consider this example of a “plain vanilla”
interest rate swap.
• Bank A is a AAA-rated international bank
located in the U.K. who wishes to raise
$10,000,000 to finance floating-rate
Eurodollar loans.
– Bank A is considering issuing 5-year fixed-rate
Eurodollar bonds at 10 percent.
– It would make more sense to for the bank to
issue floating-rate notes at LIBOR to finance
floating-rate Eurodollar loans.
An Example of an Interest
Rate Swap
• Firm B is a BBB-rated U.S. company. It
needs $10,000,000 to finance an
investment with a five-year economic life.
– Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent.
– Alternatively, firm B can raise the money by
issuing 5-year FRNs at LIBOR + ½ percent.
– Firm B would prefer to borrow at a fixed rate.
An Example of an Interest
Rate Swap
The borrowing opportunities of the two
firms are shown in the following
table:
Fixed rate
Floating rate
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
An Example of an Interest
Rate Swap
Swap
Bank
10 3/8%
LIBOR – 1/8%
Bank
A
Fixed rate
Floating rate
The swap bank makes
this offer to Bank A:
You pay LIBOR – 1/8
% per year on $10
million for 5 years and
we will pay you 10
3/8% on $10 million for
5 years
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
An Example of an Interest
Rate Swap
½ % of $10,000,000 =
$50,000. That’s quite a
cost savings per year for 5
years.
10 3/8%
Swap
Bank
-10 3/8 + 10 + (LIBOR – 1/8) =
LIBOR – 1/8%
10%
LIBOR – ½ % which is ½ %
better than they can borrow
floating without a swap.
Bank
A
Fixed rate
Floating rate
Here’s what’s in it for Bank A:
They can borrow externally at
10% fixed and have a net
borrowing position of
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
An Example of an Interest
Rate Swap
The swap bank makes
this offer to company B:
You pay us 10 ½ % per
year on $10 million for 5
years and we will pay
you LIBOR – ¼ % per
year on $10 million for 5
years.
Fixed rate
Floating rate
Swap
Bank
10 ½%
LIBOR – ¼%
Company
B
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
An Example of an Interest
Rate Swap
Here’s what’s in it for B:
Swap
Bank
½ % of $10,000,000 =
$50,000 that’s quite a cost
savings per year for 5
10 ½%
years.
They can borrow externally at LIBOR + ½ % LIBOR – ¼%
and have a net borrowing position of
Company
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25%
which is ½ % better than they can borrow
floating without a swap.
Fixed rate
Floating rate
B
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
LIBOR
+ ½%
An Example of an Interest
Rate Swap
The swap bank
makes money too.
10 3/8 %
Bank
LIBOR – ¼%
LIBOR – 1/8%
10%
¼ % of $10 million
= $25,000 per year
for 5 years.
10 ½%
Swap
Bank
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
A
10 ½ - 10 3/8 = 1/8
A saves ½ %
¼
Fixed rate
Floating rate
Company
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
B
LIBOR
+ ½%
B saves ½ %
An Example of an Interest
Rate Swap
The swap bank
makes ¼ %
10 3/8 %
Swap
Bank
LIBOR – ¼%
LIBOR – 1/8%
10%
10 ½%
Company
Bank
A
Note that the total savings
½ + ½ + ¼ = 1.25 % = QSD
B saves ½ %
A saves ½ %
Fixed rate
Floating rate
B
LIBOR
+ ½%
COMPANY B
BANK A
DIFFERENTIAL
11.75%
10%
1.75%
LIBOR + .5%
LIBOR
.5%
QSD =
1.25%
Mid1 Answers
1.
2.
3.
4.
5.
6.
(a) p72; (b) p101; © p79; (d) p83; (e) p93.
Borrow £; buy $ spot; invest $; sell $ forward.
forward. For a starting sum of £ 10,000
covered interest arbitrage profit $131.25 or
£109.375.
pp 474-481; pp 484-489;article on Law and
Finance, pp490-492.
p126, Annex 5A.
Sell Tk. buy ¥; sell ¥ buy £; sell £ buy Tk. For a
starting sum of Tk. 100,000 triangular arbitrage
profit Tk. 3834.80.
pp109-110