interest rate swap

1. Financial Derivatives (KMB FM05)
Interest Rate Swap
Prepared by :
Taru Maheshwari
Sr.Asstt.Prof. ABESEC
AKTU (Lucknow)

2. Interest Rate Swap
• An interest rate swap is a forward contract in which one stream of
future interest payments is exchanged for another based on a
specified principal amount. Interest rate swaps usually involve the
exchange of a fixed interest rate for a floating rate, or vice versa, to
reduce or increase exposure to fluctuations in interest rates or to
obtain a marginally lower interest rate than would have been possible
without the swap.

3. Interest rate Swap

4. Plain Vanilla
• There are several types of plain vanilla swaps, including an interest
rate swap, commodity swap, and a foreign currency swap. The term
plain vanilla swap is most commonly used to describe an interest rate
swap in which a floating interest rate is exchanged for a fixed rate or
vice versa.. Both legs of the swap are denominated in the same
currency, and interest payments are netted. The notional
principal does not change during the life of the swap.

5. Basis Swap
• Basis rate swaps are a form of floating for floating interest rate swaps.
These types of swaps allow the exchange of variable interest rate
payments that are based on two different interest rates.A basis rate
swap (or basis swap) is a type of swap agreement in which two
parties swap variable interest rates based on different money market
reference rates.
• For example, a company lends money to individuals at a variable rate
that is tied to the London Interbank Offer (LIBOR) rate, but they
borrow money based on the Treasury Bill rate.

6. Example
• Calculate effective rate of Interest from the following if A requires
floating interest loan and B requires fixed interest loan:
A ltd B Ltd
Fixed Rate-8% Fixed Rate-12%
Floating-LIBOR+1% Floating-LIBOR+3%

7. Solution
• Total Rate of Interest without swap
A ltd - LIBOR+1%
B ltd- 12 % so total is LIBOR+13%
After Swap
A ltd - 8%
B ltd- LIBOR+ 3 % so total is LIBOR+11%
Net Gain – 2% - 1% commission =1%
Effective Rate for A - LIBOR+1% - .5 = LIBOR+.5
Effective Rate for B - 12% - .5 = 11.5%