floating-for-fixed interest rate swap.

Interest Rate Swaps: An Example

To get a better understanding of swap contracts and the role of the swap dealer, we consider a floating-for-fixed interest rate swap. Suppose Company A can borrow at a floating rate equal to prime plus 1 percent or at a fixed rate of 10 percent. Company B can borrow at a floating rate of prime plus 2 percent or at a fixed rate of 9.5 percent. Company A desires a fixed-rate loan, whereas Company B desires a floating-rate loan. Clearly, a swap is in order. Company A contacts a swap dealer, and a deal is struck. Company A borrows the money at a rate of prime plus 1 percent. The swap dealer agrees to cover the loan payments, and, in exchange, the company agrees to make fixed-rate payments to the swap dealer at a rate of, say, 9.75 percent. Notice that the swap dealer is making floating-rate payments and receiving fixed-rate payments. The company is making fixed-rate payments, so it has swapped a floating payment for a fixed one.

Company B also contacts a swap dealer. The deal here calls for Company B to borrow the money at a fixed rate of 9.5 percent. The swap dealer agrees to cover the fixed loan payments, and the company agrees to make floating-rate payments to the swap dealer at a rate of prime plus, say, 1.5 percent. In this second arrangement, the swap dealer is making fixed-rate payments and receiving floating-rate payments. What’s the net effect of these machinations? First, Company A gets a fixed-rate loan at a rate of 9.75 percent, which is cheaper than the 10 percent rate it can obtain on its own. Second, Company B gets a floating-rate loan at prime plus 1.5 instead of prime plus 2. The swap benefits both companies.

The swap dealer also wins. When all the dust settles, the swap dealer receives (from Company A) fixed-rate payments at a rate of 9.75 percent and makes fixed-rate payments (for Company B) at a rate of 9.5 percent. At the same time, it makes floating-rate payments (for Company A) at a rate of prime plus 1 percent and receives floating-rate payments at a rate of prime plus 1.5 percent (from Company B). Notice that the swap dealer’s book is perfectly balanced, in terms of risk, and it has no exposure to interest rate volatility.

Notice that the essence of the swap transactions is that one company swaps a fixed payment for a floating payment, while the other exchanges a floating payment for a fixed one. The swap dealer acts as an intermediary and profits from the spread between the rates it charges and the rates it receives.

CONCEPT QUESTIONS

a What is a swap contract? Describe three types.

b Describe the role of the swap dealer.

c Explain the cash flows .

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