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Studying for a test? Prepare with these 7 lessons on Options, swaps, futures, MBSs, CDOs, and other derivatives.

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# Interest rate swap 2

Video transcript

In the last video company A took out a $1mn loan from lender 1 at a variable interest rate and company B took out a fixed rate $1mn loan from lender 2. and then they entered into this swap agreement where company A pays a fixed 7% every period. 7% on a notional 1mn. Notional meaning that the 1mn doesn't exchange hands, only the interest does. A pays the 7% on the notional 1mn every period to B. B pays LIBOR + 1% on that notional 1mn every period to A. So pays a variable rate on that notional amount. What I am going to do in this video is go through the numerical mechanics to show that in effect, Company A now has a fixed rate loan when you think of it from the point of view the interest it is paying and company B now has a variable rate loan. They have kind of swapped the fixed and variable natures of their loans. So lets think about what happens with company A in period 1. In period 1: So in the old period 1 it had to pay $70,000 of interest to the lender. So it had to pay in period 1, comapny A had to pay $70,000 to lender 1 but now thats not all it has to do. Definitely it still has to do that. This loan is still in effect. But now it also has to pay 7, has to pay 7% fixed to B on that notional 1mn so it also has to pay $70,000(7% on a mn) to company B, But in exchange for that, it's going to get LIBOR +1% from B. So its going to get LIBOR (we are assuming it is 5% in period1). 5% + 1% = 6%, 6% on a notional $1mn is $60,000. $60k from B. So net net it pays 70, it pays 70 twice but then it gets back 60. So its paying $80,000. So the net is paying $80,000. Now think about what happens in period 2 when LIBOR changes. So in period 2, now LIBOR changes to 4% and so A will have to pay 4% + the 2% on its loan which is 6% or $60,000. A will have to pay $60,000 to its lender. It would have to pay B the 70,000 still, it would pay to B 70,000 but in exchange it would get LIBOR + 1% from B. LIBOR is 4%. 4% + 1% is 5%. It would get $50,000. So it would get 50,000 in that period from B. So whats the total amount that it pays. It pays 60 +70 = 130,000. But then it gets back 50,000 from the swap agreement. So it pays $80,000. Notice that it doesn't change from any period.. I encourage you to try out changing the actual LIBOR rate and you see it doesn't change the amount that A pays. A is now in effect paying a fixed rate. Now the opposite is going to happen with B. In the old one, every period it pays $80,000. But now its going to be a little bit different. In period 1, it still pays $80,000 so that we can write that in every period In period 2, it still pays $80,000 and then its going to get 7% every period from company A So it would get $70,000 but its going to be paying LIBOR + 1% So in Period 1, its going to pay $60,000. And then in period 2, its going to pay $50,000. So net you pay 50, you get 70 so thats a part of, you are still paying 10 and you pay another 60 So net is your going to pay 70k in period 1 and then in period 2, you're going to pay 60k So now Comapny A is paying a fixed 8% every period. and company B is going to pay essentially a variable rate.