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Current time:0:00Total duration:3:51

Video transcript

let's say that we've got company a over here and it takes out a 1 million dollar loan takes out a 1 million dollar loan it plays a variable interest rate on that loan it pays LIBOR LIBOR plus 2 percent 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 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 let's say LIBOR goes down a little bit to 4% then Company A is going to pay 4 plus 2 which is 6% or 6% which is $60,000 in interest $60,000 in interest let's say that we have another company Company B right over here it also borrows $1,000,000 but it bars it at a fixed rate let's say it borrows it at a fixed rate of 8% 8% fixed interest rate so in each period regardless of what happens to LIBOR what any other benchmark and so this is to probably another lender a different lender than the person that I borrowed it from and it could be a bank or it might be another company or an investor of some kind we will call this lender 1 and lender 2 so regardless of the period right now Company B will pay 8% of 1 million dollars in each period and that which is about $80,000 or exactly $80,000 each period now let's say that neither of these parties are really happy with that situation Company A doesn't like the variability the unpredictability in what happens to LIBOR and they so they don't 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 are doing variable interest rates they're paying a less amount of interest every every period and maybe they also 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 a bigger why they want to become a variable rate borrower so what they can do and they 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 and this would be called an interest rate swap where company a company a agrees to pay B maybe let's let's make up a number here seven percent on a notional notional one million dollar loan so no the 1 million dollars will never change hands but company a agrees to pay B seven percent of that notional one million dollars or seventy thousand per period and in return in return Company B Company B agrees to pay a a variable rate let's say it's LIBOR let's say it's LIBOR plus one percent right over here and this little agreement and they agree they would agree to do this for some amount and once again this is live where plus one percent on a notional on a notional one million and that word notional just means that that 1 million will never change hands that they're just going to exchange the interest payments on 1 million dollars and this Agreement right over here this Agreement right over here is called an interest rate swap and I'll leave you there in the next video we'll actually go through the mechanics to see that a is truly now paying 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 is now really paying a variable interest rate