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Course: Finance and capital markets > Unit 9
Lesson 6: Interest rate swapsInterest rate swap 1
Google ClassroomThe basic dynamic of an interest rate swap. Created by Sal Khan.
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So this might be a silly question, but can lenders also enter into this sort of swap? I can see scenarios where it might be mutually beneficial.(4 votes)- Yes. Both parties can enter a swap in order to alter their interest rate exposure.(6 votes)
How is LIBOR determined?(2 votes)
Each day, the British Bankers Association surveys the 18 major global banks that are based in London and deal in US dollars. The BBA asks the banks how much interest they would be willing to pay on borrowed funds. It takes the 18 answers, throws out the highest 4 and the lowest 4, and averages the middle 10. The average that it receives is the LIBOR.(8 votes)
is that called a plain vanilla swap?(3 votes)- Vanilla Swap is also often used to describe a plain Swap.
On the contrary there are Swaps, that are designed to match the cash-flow of an underlying business. For example, a Ski Resort Hotel will have revenues that mostly occur in winter. As such, their financiers may tailor a Swap into a Roller Coaster profile (Roller Coaster Swap) to match the seasonality of the business. The name as it suggests is a swap profile that goes up and down.
Another commonly used Swap is an Amortising Swap, which as in this case the name suggests it decreases in value over time.(2 votes)
- If say company didn't want a loan at a variable exchange rate, why not directly go to lender 2.?
Given that lenders are banks in most cases, I think both of them have the option to choose the alternate interest rate at the time of the loan itself, ain't it.?(2 votes)- In practice, the two companies would usually not be swapping with each other directly, but would go through a financial intermediary, like a bank. Banks, in turn, make money off of these swap agreements that the banks broker with some fees and arbitrage.
As a result, the swap agreement is usually part of a larger financing package that the company is getting from the bank. The bank may offer the borrower a fixed rate for five years, subject to adjustments (variable rate) thereafter, OR the borrower could enter into a swap and the interest rate would be fixed for 10 or 15 years. The bank shifts the risk onto the party who ends up buying the swap and makes a little bit of money for its brokering, and the borrower gets some predictability in its payments for a longer period of time.
In essence, you're right that these companies would arrange for their preferred interest scheme at origination, with the lenders directly, but its the lenders who will arrange these swaps to balance the borrowers preferred interest scheme with the lender's risk appetite.
Additionally, rapidly changing market conditions (like the sudden onset of recession) may cause a borrower to rethink its preferred interest scheme, but it may be already locked into a loan with a significant refinance penalty, making a swap a cheaper option to restructure its debt.(2 votes)
I thought that interest rate swaps were meant to completely offset the interest paid -- paying the exact amount that the other company is paying -- to be completely effective at switching the rates. They don't need to use the exact interests rates to accomplish their goal?(1 vote)
http://www.investinganswers.com/financial-dictionary/optionsderivatives/interest-rate-swap-2252
This page explains well.
Sal does make it a bit confusing.(1 vote)
- How do they calculate the interest rate swaps? It's not clear to me how each of them benefit from this type of agreement?(1 vote)
- Interest rate swaps are calculated so that a party, or company in this case, would be indifferent, at the moment the swap rate is calculated, to paying the fixed swap rate or the floating rate. Both companies benefit and the reasons they benefit aren't clear because you don't know enough about the two companies. Please refer to my answer on the second video. The other argument is the comparative advantage argument; it has been said that this argument plays a lesser role in today's market. The argument states that one company has an advantage by borrowing at a fixed rate and the other at a floating rate. They have further advantage by then swapping.(1 vote)
1) Is the U.S Government aware of this "Interest Rate Swap (IRS)" ? Also, is IRS legal anyway ?
2) If A gives B a LIBOR + 2, equivalent to 7% variable Interest, it would only be $70k notional, wouldn't it ? B is supposed to pay Lender a fixed $80k, therefore B would definitely be in short of $10k, right ? How does it manage to resolve this problem ?(1 vote)
is there interest rate swap markets for mortgage "housing"?(1 vote)- Technically you could enter into a interest rate swap agreement on your mortgage but in practice there is no active market in this. If you went to your bank and asked them to write you an otc swap they would probably just offer to refinance your loan rather than swap with you.(1 vote)
- what is the difference between interest rate swap and a currency swap(0 votes)
what does it sound like the difference might be?(1 vote)
- Are the swap interest rates (7% and LIBOR + 1%) calculated somehow or are they just random interest rate market estimates? Thanks(0 votes)
- They are for illustrative purposes in this example.(1 vote)
Video transcript
Let's say that we've
got company A over here, and it takes out
a $1 million loan, and it pays a variable
interest rate on that loan. It pays LIBOR plus 2%. And LIBOR stands for London
Interbank Offer Rate. It's one of the major benchmarks
for variable interest rates. And so it pays that
to some lender. This is the person who
lent company A the money. It pays them a variable
interest rate every period. So for example, in period
one if LIBOR is at 5%, then in that period, company
A will pay 7%, or $70,000 to the lender in that period. In period two, if
LIBOR goes, let's say LIBOR goes down a
little bit to 4%, then company A is going to
pay 4 plus 2, which is 6%, which is $60,000 in interest. Let's say that we have
another company, company B, right over here. It also borrows $1 million, but
it borrows it at a fixed rate. Let's say it borrows it
at a fixed rate of 8%. So in each period,
regardless of what happens to LIBOR or any
other benchmark-- so this is to probably another
lender, or different lender, than the person that
A borrowed it from. And it could be a
bank, or it might be another company, or
an investor of some kind. We will call this
Lender 1 and Lender 2. So regardless of the
period, right now company B will pay
8% of $1 million in each period, which
is about $80,000, or exactly $80,000, each period. Now let's say that
neither of these parties are really happy
with that situation. Company A doesn't
like the variability, the unpredictability in
what happens to LIBOR, so they can't plan for
how much they have to pay. Company B feels like they're
overpaying for interest. They feel like, wow, the people
who are doing variable interest rates, they're paying a
less amount of interest every period. And maybe they also,
company B also, thinks that interest rates
are going to go down, or that short term,
or that variable rate is going to go down,
LIBOR is going to go down. So that's an even
bigger reason why they want to become a
variable rate borrower. So what they can do,
and neither of them can get out of these
lending agreements, but what they can do is
agree to essentially swap some or all of their
interest rate payments. So for example, they can
enter into an agreement, and this would be called an
interest rate swap, where company A agrees
to pay B-- maybe, let's make up a number here-- 7%
on a notional $1 million loan. So, the $1 million will
never change hands, but company A agrees to pay B
7% of that notional $1 million, or $70,000 per period. And in return, company B agrees
to pay A a variable rate. Let's say it's LIBOR
plus 1%, right over here. And this little
agreement-- and they agreed they would agree to
do this for some amount. And once again, this
is LIBOR plus 1% on a notional $1 million. And that word notional
just means that $1 million will never change
hands, and they're just going to exchange the interest
payments on $1 million. And this agreement
right over here is called an interest rate swap. And I'll leave you there. In the next video,
we'll actually go through the mechanics to
see that A is truly now paying a fixed rate when you put in
all of their different payments into both the swap
and the lender, and Company B, after entering
into this swap agreement, is now really paying a
variable interest rate.