Financial Engineering Project Course

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Financial Engineering Project Course
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Lecture 2

• Swaps
• Homework 2
• More Java Fundamentals

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Interest Rate Swaps
5.0
Company B
Company A
LIBOR Rate
Source John C. Hull
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Interest Rate Swaps
5.0
Company B
Company A
LIBOR Rate
Suppose we have a three-year swap initiated on
March 1, 1999, in which company B agrees to pay
company A an interest rate of 5 per annum on
notional principal of 100 million and in return
company A agrees to pay company B the six-month
LIBOR rate on the same notional principal.
Source John C. Hull
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Cash flow (in millions) to Company B in a 100
Million Three Year Interest Rate Swap when a
fixed rate of 5 is paid and LIBOR is received
Date LIBOR Floating Cash Flow received Fixed Cash Flow Paid Net Cash Flow
3/1/99 4.2
9/1/99 4.8 2.10 -2.5 -0.40
3/1/00 5.3 2.40 -2.5 -0.10
9/1/00 5.5 2.65 -2.5 0.15
3/1/01 5.6 2.75 -2.5 0.25
9/1/01 5.9 2.80 -2.5 0.30
3/1/02 6.4 2.95 -2.5 0.45
Source John Hull
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Cash flow (in millions) to Company B in a 100
Million Three Year Interest Rate Swap when a
fixed rate of 5 is paid and LIBOR is received
Six exchanges of payments
Date LIBOR Floating Cash Flow received Fixed Cash Flow Paid Net Cash Flow
3/1/99 4.2
9/1/99 4.8 2.10 -2.5 -0.40
3/1/00 5.3 2.40 -2.5 -0.10
9/1/00 5.5 2.65 -2.5 0.15
3/1/01 5.6 2.75 -2.5 0.25
9/1/01 5.9 2.80 -2.5 0.30
3/1/02 6.4 2.95 -2.5 0.45
Company B is always Paying the (5.0/2) To its
swap partner. 2.5 million
Source John Hull
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Cash flow (in millions) to Company B in a 100
Million Three Year Interest Rate Swap when a
fixed rate of 5 is paid and LIBOR is received
The floating rate payments on the payment date
are calculated using the six month LIBOR rate
prevailing six months before the payment date.
Date LIBOR Floating Cash Flow received Fixed Cash Flow Paid Net Cash Flow
3/1/99 4.2
9/1/99 4.8 2.10 -2.5 -0.40
3/1/00 5.3 2.40 -2.5 -0.10
9/1/00 5.5 2.65 -2.5 0.15
3/1/01 5.6 2.75 -2.5 0.25
9/1/01 5.9 2.80 -2.5 0.30
3/1/02 6.4 2.95 -2.5 0.45
Source John Hull
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Cash flow (in millions) to Company B in a 100
Million Three Year Interest Rate Swap when a
fixed rate of 5 is paid and LIBOR is received
Company B pays Company A (2.5 2.1) Million
0.4 Million
Date LIBOR Floating Cash Flow received Fixed Cash Flow Paid Net Cash Flow
3/1/99 4.2
9/1/99 4.8 2.10 -2.5 -0.40
3/1/00 5.3 2.40 -2.5 -0.10
9/1/00 5.5 2.65 -2.5 0.15
3/1/01 5.6 2.75 -2.5 0.25
9/1/01 5.9 2.80 -2.5 0.30
3/1/02 6.4 2.95 -2.5 0.45
Source John Hull
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Using the Swap to transform a liability
Perhaps Company B would like to transform a
floating rate loan to a fixed rate loan. Suppose
that company B has arranged to borrow 100
Million at LIBOR plus 80 basis points. (1 basis
point one-hundredth of 1) After entering into
the swap, it has three sets of cash flows
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Using the Swap to transform a liability

• It pays LIBOR plus 0.8 to its outside lenders.
• It receives LIBOR under the terms of the swap.
• It pays 5 under the terms of the swap.
• Post swap interest rate payment 5.8 per annum
  (fixed)

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Using the Swap to transform a liability
For company A, the swap could have the effect of
transforming a fixed-rate loan into a
floating-rate loan. Suppose that company A has a
three year 100 million loan outstanding on which
it pays 5.2 per annum. After it has entered
into the swap, it has three sets of cash flows
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Using the Swap to transform a liability

1. It pays 5.2 per annum to its outside lenders.
2. It pays LIBOR under the the terms of the swap.
3. It receives 5 per annum under the terms of the
   swap.

This nets out to an interest rate payment of
LIBOR 0.2. Or, LIBOR plus 20 basis points.
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Using the Swap to transform a liability
LIBOR 0.8
5.2
5
Company A
Company B
LIBOR
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Role of Financial Intermediary
LIBOR 0.8
5.2
Company A
Company B
4.985
LIBOR
5.015
LIBOR
Financial Institution
Source John Hull
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Homework 2Class exercise

Write an object-oriented program in Java that
simulates the mechanics of an interest rate
swap.