Interest Rate Swaps

1
Interest Rate Swaps

• Swaps are arrangements whereby firms exchange
  cash flows determined with different interest
  rates
• History Began in the late 1970s
• Currently the mkt. Is more than 10 trillion.

2

• Interest Rate Swaps are the most common type of
  swap.
• The basic swap involves
• Fixed-Rate Payer
• Floating-Rate Payer
• There is a basic amount of principal (notational
  amount)
• Today, swaps are arranged brokers and dealers
  such as banks and investment banks.

3
Swap Illustrated
4
Problem

• SL has 100 million in fixed-rate loans earning
  8.5 percent. The SL also has 100 million in
  floating-rate CDs, which earn the Fed Funds rate
  less 1 percent. It wants to swap with a
  commercial bank. SL will pay 7.5 fixed and
  receive the Fed Funds rate plus 1 percent. The
  Fed Funds rate is currently at 5.5 percent.
• What If Fed Funds stay at 5.5 percent?
• What If Fed Funds rise to 6.5 percent?
• What If Fed Funds drop to 5 percent?
• Show the effects on SL Profits

5

• SL Before the Swap
• Income
• Mortgages 100,000,000 8.50
  8,500,000
• Expense
• CD's 100,000,000 4.50
  (4,500,000)
• Profit 4,000,000

6

• SL After the Swap FF _at_ 5.5
• Income
• Mortgages 100,000,000 8.50
  8,500,000
• Expense
• CD's 100,000,000 4.50
  (4,500,000)
• Net 4,000,000
• Swap
• Income 100,000,000 6.50 6,500,000
• Payment 100,000,000 7.00 (7,000,000)
• Net (500,000)
• Profit 3,500,000

7

• SL After the Swap FF _at_ 6.5
• Income
• Mortgages 100,000,000 8.50
  8,500,000
• Expense
• CD's 100,000,000 5.50
  (5,500,000)
• Net 3,000,000
• Swap
• Income 100,000,000 7.50 7,500,000
• Payment 100,000,000 7.00 (7,000,000)
• Net 500,000
• Profit 3,500,000

8

• SL After the Swap FF _at_ 5.0
• Income
• Mortgages 100,000,000 8.50
  8,500,000
• Expense
• CD's 100,000,000 4.00
  (4,000,000)
• Net 4,500,000
• Swap
• Income 100,000,000 6.00 6,000,000
• Payment 100,000,000 7.00 (7,000,000)
• Net (1,000,000)
• Profit 3,500,000

9
Analysis of the Swap

• Net Income Net Income
• FF Rate Before Swap With Swap
• 5.5 4,000,000 3,500,000
• 6.5 3,000,000 3,500,000
• 5.0 4,500,000 3,500,000
• The Swap reduces the variance (risk) of income.

10
Hedging with Swaps Compared to Options Futures

• Swaps are easily set up and reversed through
  large banks and brokerage cos., which guarantee
  them.
• Swaps can be set up for 3 to 5 years.
• There is no marking to market, or margin calls
  with swaps.