The Mechanics of Interest Rate Swaps

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The Mechanics of Interest Rate Swaps

• Amazingly Presented By
• Greg Mendonca

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Outline

• Origins of interest rate swaps
• Plain Vanilla interest rate swaps
• Example of a plain vanilla swap
• Comparative advantage
• Other uses for swaps

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Origins of Interest Rate Swaps
1981 Interest Rate Rise Banks trying to protect
against the rising short term interest rates
World Bank and IBM Origin US Rates vs. German
Rates vs. Swiss Rates IBM swapping debt
obligations with World Bank in order to lower
interest for both World Bank and IBM
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Plain Vanilla Swap

• Two Basic Actions
• Firm A pays a fixed rate of interest to Firm B on
  a predetermined notional value
• Firm B pays a floating rate of interest to Firm A
  on the same notional value
• Netting of the payments amount
• Fixed rate agreed upon, floating rate based on
  either US T-Bill or London Interbank Offered Rate
  (LIBOR) plus a base point premium

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Example of Plain Vanilla Swap

• Banks
• Lending long-term (fixed rate mortgages)
• Insurance Companies
• Investment portfolio (floating rate bonds)

Notional Amount
------------gt lt------------
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Example cont.
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Theory of Comparative Advantage

• Some entities have a comparative advantage
• One entity may have an advantage in fixed rate
  markets
• One entity may have an advantage in floating rate
  markets
• Using each entities comparative advantage they
  could enter an interest rate swap in order to
  leverage their advantage to another company and
  earn a spread

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Comparative Advantage cont.
If the bank uses their comparative advantage on
their commercial loan portfolio, they can earn a
spread income from the swap
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Other Uses For Swaps

• Reducing funding costs
• Company looking to raise funds issues fixed rate
  6 month papers and enters into swap to receive
  floating rate
• Asset/Liability management
• Changing payments streams from fixed to variable
  and vice versa
• Speculative positions
• Enter into swap take a position gaining from
  either a drop or rise in interest rates

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Time To Say Goodbye