Interest rate swaps made easy
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mefielding presents interest swaps made easy. Especially useful for accounting students or those who are considering using swaps and want to understand how they work
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Interest rate swaps made easy
- 2. Interest Rate SWAPS A swap is the situation where 2 companies borrow money. They (sort of) pay each others interest and by doing this they save money Steel Co is a large company, asset backed. It wants to borrow $25m fixed rate because it believes interest rates will rise. An investment bank tells it, it can borrow floating rate (bank) at LIBOR +20 or fixed rate (bond market) at 5%. Acconting Co is a consulting group. It has a long history of profits and has a good credit rating. Acconting believes interest rates will fall and wants to borrow $25m floating rate. The investment bank tells Acconting it can borrow at LIBOR +90 or fixed 5.20% The investment bank offers to organize an interest rate swap for a fee of 10 basis points jointly payable from interest payments Both loans have a life of 5 years mefielding.com 2
- 3. Interest Rate SWAPS Step 1 Calculate the differential, this is the profit to be shared mefielding.com 3 Floating Fixed % Steel LIBOR +20 5 Acconting LIBOR+ 90 5.20 Steel’s advantage 70 20
- 4. Interest Rate SWAPS- Step 2 The differential is 50 basis points (0.5%) This will be split 10 basis points to the bank and 20 basis points to each company. First draw the outline mefielding.com 4 Acc Bank Steel
- 5. Interest Rate SWAPS Steel is the largest company, therefore we start with Steel. Steel will issue into the market in which it has the largest advantage. From slide 3 this is the floating rate Steel will therefore borrow $25m from a bank and Acconting will issue bonds with a value of $25m mefielding.com 5
- 6. Interest Rate SWAPS Steps 3 &4 mefielding.com 6 Acc Bank Steel LIBOR+20 5.20% LIBOR+90 LIBOR+90
- 7. Interest Rate SWAPS Current situation for Steel is that it is receiving 70 basis points (0.7%) We said originally (slide 3) they had to pay 5% but would receive 20 basis points of benefit. The net cost therefore must be 4.8% If Steel is currently receiving 0.7% then Steel must pay fixed 5.5%- gives net 4.8% The bank will take 10 basis points as its fee so Acconting receives 5.4% mefielding.com 7
- 8. Interest Rate SWAPS mefielding.com 8 Acc Bank Steel 5.20% LIBOR+20 LIBOR+90 LIBOR+90 5.5%5.4%
- 9. Interest Rate SWAPS Steel pays LIBOR +20 and 5.5% but receives LIBOR+90. Net 4.8% fixed which is 20 basis points less than they would have expected Acconting pays 5.2% and LIBOR+90 but receives 5.4%. The net is LIBOR plus 70 which is 20 basis points less than if they had borrowed floating mefielding.com 9
- 10. Risks of Interest Rate SWAPS Floating rate risk Basis risk Default risk mefielding.com 10