BONUS
Exotic Investments
Lesson 2
Interest Rate and
Credit Default Swaps
Swaps
Aim:
 How can swaps be used to help
businesses succeed?
Do Now:
 Identify the risk a bank or investor has
when loaning money to a company.
Swaps
 Do Now answer: That the company
borrowing the money might not be able to
pay it back.
Interest Rate Swaps
In an interest rate swap, two market participants,
known as counterparties, agree to exchange
interest payments for a set period of time, typically
from 1-5 years.
One counterparty makes a payment based on a
fixed rate of interest, while the other counterparty
makes a payment based on a floating rate of
interest.
Interest Rate Swaps
Example: Company A is borrowing money at a
fixed rate of 6%.
Company B is borrowing the same amount of
money at a variable rate of: 3.5% plus LIBOR (the
London InterBank Offered Rate), a benchmark for
many loans that moves up and down.
Let’s say that LIBOR is currently .5%, meaning that
Company B’s variable rate is currently 3.5% + .5%
= 4.0%.
Interest Rate Swaps
Example (cont.): Company A, seeing that the
variable rate loan rate is lower (and believing that
interest rates will not rise for a long time), could
make an offer to Company B that would swap A’s
fixed rate for B’s variable rate.
It could offer to pay Company B interest of 4% +
LIBOR and in return receive payment from
company B of 5.5%.
Interest Rate Swaps
Example (cont.): At this point, Company A would
owe 6% to its original lenders and 4% (plus
whatever the LIBOR rate is) to Company B. This
results in its obligations being 10% + LIBOR. It will
receive back from Company B 5.5%. This results in
its final obligations being 10% - 5.5% = 4.5% plus
LIBOR (which is currently .5%).
It just lowered its current interest rate from 6% to
5% (4.5% + .5%), but it has taken on the risk that
interest rates may rise!
Interest Rate Swaps
Example (cont.): Company B originally owed 3.5%
+ LIBOR interest on its loan. It has further promised
in the swap to pay Company A 5.5%. Its total
responsibility for interest payments is 9% + LIBOR.
However, Company A has agree to pay it whatever
LIBOR is, plus 4%. Company A’s promise to cover
LIBOR cancels out the variability of the rate.
Company B is left with a fixed rate loan of 9% - 4%
= 5%. It is paying 1% more than earlier, but it has
removed the risk that interest rates may rise!
Credit Default Swaps (CDS)
A swap that transfers the credit exposure of fixed
income products (ie: loans) between parties
 Buyer of the swap receives credit protection and the
seller of the swap guarantees the credit worthiness of
the fixed income security
 The risk of the default is transferred from the holder of
the fixed income security to the seller of the swap
Risk of
default
Swap
Seller
Buyer
Credit
Protection
Credit Default Swaps (CDS)
Example:




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I.N. Vestor buys a $1,000,000 Frizzle,Inc. bond.
He wants protection against loss of principal in the event
Frizzle, Inc. defaults on payment.
He buys a credit default swap contract from a third party.
I.N. Vestor makes periodic payments to the third party so
that it continues to keep the credit default swap in force.
If Frizzle, Inc. defaults during the time period that I.N.
Vestor has paid for coverage, then the third party
reimburses I.N. Vestor the face value of the Frizzle, Inc.
bond ($1,000,000).
Note: If this sounds like insurance, it basically is!
Credit Default Swaps (CDS)
Uses for Swaps
Hedging:

Hedging activities reduce risk. A borrower may enter into an
interest rate swap to remove the risk that a benchmark such as
LIBOR goes higher, which would require it to pay more.

A purchaser of a credit default swap is buying insurance, which
is the primary method for reducing risk.
Speculation:

An investor may take on the risk of paying a variable rate of
interest (in return for a fixed rate) if it believes (ie: speculates)
that rates will stay low and it will make a profit from the decision.

A buyer of a credit default swap (who does not own a bond and
has no risk) is betting that a company will fail!
Lesson Summary
1. In an interest rate swap, what are the two
parties exchanging?
2. What are the two parties formally known as?
3. What is a purchaser of a credit default swap
acquiring?
4. What is this protection commonly called?
5. What are the two general uses for swaps?
6. How can swaps be used to help businesses
succeed?
Web Challenge #1
Challenge: LIBOR is an interest rate on which
the interest rate of trillions of dollars are based.
1. Research how LIBOR was set up through
2013.
2. Identify what happened in 2012 that
shocked the financial world. (Hint: Search
using “rate fixing”).
3. Identify how LIBOR is currently arrived at.
Web Challenge #2
Challenge: The rampant and unregulated use
of Credit Default Swaps (CDSs) were a major
contributor to the stock market crash of 2008
and the Great Recession. Research which firm
sold the most CDSs and which consequently
was not able to pay off the insurance it had sold
when firms like Lehman Brothers failed. (Hint: It
required a bailout from the U.S. Government in
the neighborhood of $180 billion to make good
on its insurance promises!)
Web Challenge #3
Challenge: One of the goals of any market is to
be transparent. Transparency means that its
activities can be seen and understood by the
participants. After the crash of 2008, regulators
realized that the multi-trillion dollar credit
default swap market had to come out of the
shadows and be subject to scrutiny. Research
and identify how the reforms in the Dodd Frank
Wall Street Reform Act have brought
transparency to the CDS market.