This document explains the concept of interest rate swaps between two companies, detailing their borrowing choices and potential savings. Company A prefers a fixed rate due to expectations of rising rates, while Company B opts for a floating rate anticipating a decline. The document also discusses risks and reasons financial institutions engage in such swaps, including hedging against losses and managing credit risk.

1. 1

2. 2
A swap is the situation
where 2 companies
borrow money. They pay
each others interest and
by doing this they save
money

3. IRS EXAMPLE
• company A is a large company, asset backed. It wants to
borrow $1M. bank tells it, it can borrow floating rate at
LIBOR +20 or fixed rate at 5.40%. the company thinks that
interest rate may go up and choose fixed interest rate
• company B is a consulting group. It has a long history of
profits and has a good credit rating. It wants to borrow $1m.
The bank tells company B it can borrow at LIBOR + 80 or
fixed 5%. the company thinks that interest rate may get down
and choose floating interest rate
• The investment bank offers to organize an interest rate
swap for a fee jointly payable from interest payments.
• now the investment banks tells the company A to get that
loan for floating at LIBOR + 20 and company B for fixed at 5%

4. The word basis in the term
basis point comes from the
base move between two
percentages, or the spread
between two interest rates.
Since the changes recorded are
usually narrow, and because
small changes can have
outsized outcomes, the basis is
a fraction of a percent.
BPs

6. Interest rate offered by the lender
Floating Fixed %
Company A LIBOR +20 5.40
Company B LIBOR+ 80 5
Floating Fixed %
Company A LIBOR +20 5.20 (IRS)
Company B LIBOR+ 50 (IRS) 5
Interest rate swap agreement organized by the
investment banks

7. LIBOR
• LIBOR is the benchmark interest rate at which major
global banks lend to one another. LIBOR is
administered by the Intercontinental Exchange, which
asks major global banks how much they would charge
other banks for short-term loans
• The London Interbank Offered Rate (LIBOR) is meant to
reflect the average interest rate major banks charge
each other to borrow.
• LIBOR is normally published at 11:55 am London time
on each applicable London business day for all
applicable currencies and tenors, except as described
below. There is no LIBOR publication in any currency or
tenor if the date is a London public holiday.

8. Other Benchmark Interest Rate
• Secured Overnight Funding Rate (SOFR)
• Federal Funds Rate
• Ameribor
• Bloomberg Short-Term Bank Yield (BSBY) Index
• SONIA (Sterling Overnight Index Average )

9. Example of interest Rate Swaps
Company B Investment
Bank
Company A
5%
LIBOR+20
LIBOR+ 50 LIBOR+ 40
5.20%
5.10%
Lender bank
Lender bank

10. Interest Rate SWAPS
• Current situation for company A is that it is
receiving libor + 40 basis points and it paying
only libor + 20 basis point to the lender.
• current situation for company B is that it is
receiving 5.10% of fixed interest where it
wants to pay only 5%.

11. Risks of Interest Rate Swaps
Floating rate risk
• Actual interest rate movements do not
always match expectations.
Default risk
• This is the risk that the other party in the
contract will default on its responsibility.

12. Basis swap
• A basis swap is an interest rate
swap which involves the exchange of
two floating rate financial instruments.
A basis swap functions as a floating-
floating interest rate swap under which
the floating rate payments are
referenced to different bases.

13. Example
A company lends money to individuals at a variable rate that is tied to
the London Interbank Offered Rate (LIBOR), but they borrow money based
on the Treasury Bill (T-Bill) rate. This difference between the borrowing and
lending rates (the spread) leads to interest rate risk, which refers to the
potential that a change in interest rates could lead to investment losses. By
entering into a basis rate swap—where the company exchanges the T-Bill
rate for the LIBOR rate—the company eliminates this interest rate risk.

14. Primary reasons why financial
institutions use interest rate swaps
• Hedge against losses
• Manage credit risk
• Speculate