25 years: Trading & derivatives
David provides an overview of interest rate swaps - what they are, why they are used, typical parties involved and key components of the derivative.
David provides an overview of interest rate swaps - what they are, why they are used, typical parties involved and key components of the derivative.
17 mins 57 secs
An interest rate swap (IRS) is an over-the-counter derivative contract between two parties who agree to exchange a series of future interest rate payments. One of the parties commits to paying a series of fixed payments over the life of the contract; the other commits to paying a series of floating-rate payments.
Key learning objectives:
Define the key components of and parties to an interest rate swap
Explain a liability swap and how they are used
Explain an asset swap and how they are used
A liability swap is an arrangement where a company sells a fixed-rate bond to investors but enters into an interest rate swap with a bank to receive fixed-rate payments (which it passes to its bond investors) and pays a floating-rate (typically LIBOR) to the bank counterparty.
Most investors like to know exactly what return they will be getting, so most bonds are issued with fixed rates, which sets their liabilities for the life of the bond. But many companies prefer to have liabilities that float in line with the performance of the economy. So if they issue fixed-rate bonds and swap their fixed-rate liabilities for floating-rate ones, they achieve twin aims of selling fixed-rate bonds to investors but having liabilities more closely match the performance of the economy and their own business. This need is particularly acute for companies in cyclical sectors, since when the economy deteriorates they can reasonably expect interest rates to fall, thereby reducing their interest costs.
If the rate at which a company can borrow from investors matches the swap counterparty’s quoted swap rate of, say, 5%, the cash flows in effect cancel each other out. But on a given day, the market might demand that one issuer pays 5% but that another pays 5.5% because of its worse credit rating. Since there is only one rate for a five-year swap in a given currency, any differential to the bank’s swap rate is accommodated in a spread over the floating rate. So a bank paying 5.5% fixed to the worse credit receives LIBOR + 0.50% (or 50 basis points).
An investor wanting to own a bond of a given company in floating-rate format can buy a fixed-rate bond and enter into an IRS with a bank counterparty whereby the investor pays the fixed coupon to the bank against a swap notional that matches the amount of bonds they have bought; the bank pays a floating rate to the investor. This is an asset swap.
In another example, an investor identifying a bond of a company paying a 6% fixed coupon trading at a price of 95 can enter into an asset swap with a bank counterparty, whereby the bank buys the bond at 95 and sells it to the investor at 100 via an IRS. The bank receives the 6% coupon and pays the investor a spread over LIBOR. The size of the spread is calculated from:
a) The difference between the five-year swap spread and the 6% coupon i.e. 1% or 100bp
b) The difference between the purchase price of the bond (95) and par (100)
If the five-year swap rate is 5%, the bank pays 1% (or 100 basis points) over LIBOR to make up the difference to the 6% coupon on the bond. But the bank has also taken 5% of the value of the bond upfront (i.e. it bought the bond five points below par but sold it to the investor at 100). This upfront payment is also distributed through the spread over LIBOR. If that 5% is spread out over the five-year life of the bond, that equates to another 100 basis points, giving the investor an asset yielding LIBOR plus 200bp.
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