Interest rate swaps
Interest Rate Swap 1 The basic dynamic of an interest rate swap
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- Let's say we've got company A over here
- and it takes out a $1,000,000 loan
- and 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 1
- 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 2, if LIBOR goes down a little bit to 4%
- then company A is going to 4 + 2 which is 6%
- or, 6% which is $60,000 in interest.
- Let's say we have another company
- company B, right over here
- It also borrows $1,000,000
- but it borrows it at a fixed rate of 8%
- 8% fixed interest rate
- so in each period
- regardless of what happens to LIBOR
- or any other benchmark
- and so this is to probably another lender
- a different lender than the person that A borrowed it from
- and it could be a bank, or it may be a company
- or another investor of some kind
- We'll call this Lender 1 and Lender 2
- So, regardless of the period
- right now company B will pay
- 8% of $1,000,000 in each period
- which is exactly $80,000 each period
- Now let's say neither of these parties
- are really happy with that situation
- Company A doesn't like the variability
- the unpredictability and what happens to LIBOR
- 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're doing variable interest rates,
- they're paying a less amount of interest every period"
- and maybe 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
- 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 $1,000,000 loan.
- So the $1,000,000 will never change hands
- but company A agrees to pay B
- 7% of that notional $1,000,000
- 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 agree they would do this for some amount
- And once again: this is LIBOR plus 1%
- on a notional $1,000,000
- And that word "notional" just means that
- that $1,000,000 will never change hands
- they're just going to exchange
- the interest payments on $1,000,000
- And this agreement right over here
- is called an interest rate swap
- And I'll leave you there and 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
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