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Course: Finance and capital markets > Unit 9
Lesson 6: Interest rate swapsInterest rate swap 2
Created by Sal Khan.
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Is there a reason why the swap only pays LIBOR + 1% instead of Libor + 2% which is the variable rate that "A" actually pays?(21 votes)- I believe that the learning point here is that B's payment to A is linked to LIBOR so it's variable, while A's payment to be is fixed. The net result, as Sal explains, is that A's net payments are fixed and B's are variable. I don't think the + 1% or + 2% is meaningful (that is, I think that number was simply chosen by Sal as an example), and I believe that where this additional percentile is set would simply depend on the bargaining process between the parties. If the parties set the additional % as 0 or as 5 %, they would still achieve the same result of swapping a variable/fixed rate for a fixed/variable rate, and the changes would only affect which side is benefiting more from the agreement.(19 votes)
- Why would A agree to do this kind of swap? It's just losing money in the contract. And,if the notional % that B pays would be higher, why would B go in to such a deal?? It just makes sense (profit) for one of the companies going in to the deal. The other has to always pay more than in it's original loan agreement with it's lender.(9 votes)
I can think of a couple of scenarios. First, company A may think that the benchmark is about to plummet while company B thinks it will rise. It is in A's interest to get a variable rate and in B's interest to get a fixed rate. One will end up losing out, but the swap makes sense at the time. Second, if A is a company with high liquidity and low profits, while B is a company with low liquidity and high profits, B may be willing to pay a premium on its lending for the certainty that a fixed rate brings, even if that rate is above the market rate. Do you understand?(25 votes)
- Is there a price for this swap agreement? Does a difference in the credit ratings of the two actors cause one to pay a risk premium ?(5 votes)
You have two questions.
First question: "In theory", the answer is no. Why would you enter into an agreement where you are at a loss? The swap rate should be such that you are indifferent to pay floating or fixed at that moment in time. A swap rate, again "in theory", is set to a rate such that the present value of the transaction is zero but this is more complicated than for the purposes of this video. I say "in theory" because this isn't how the real world works. The truth is is that you won't know the counterparty you are swapping with most of the time. You would call a bank. The bank will charge you a fee to enter into a swap. Kind of like the stock market, a bank is willing to sell you a swap for more than it is willing to buy a swap. This is known as the bid/ask spread or the bid/offer spread. By paying the fee that banks charge, the present value of the agreement is not zero anymore.
Second question:
In a way, yes. Say a counterparty is riskier than usual, then a bank will charge you more to enter into a swap agreement. How do they do this? They will widen the bid/offer spread. They will stand by to buy a swap cheaper and sell one more expensive to a riskier counterpart.
Hope this helps.(8 votes)
How does Interest Swap treated on the Income Statement? Would it change the Income before Tax?(6 votes)
Yup, it would impact their interest expense. Ideally in the direction that they want it to. In the example that Sal gave, company A's income statement will be adversely impacted to the extent that LIBOR + 2% is above the 7% that it pays to company B. Same case for company B as well.(3 votes)
- how would this change if company A and company B used two different currencies aka a currency swap?(6 votes)
- Excellent question. Generally the risk-free rate is different in each currency. You can treat each currency like a bond that is paying its own variable rate and go from there.(1 vote)
- Will the swap still work if each company had borrowed a different amount in the beginning?(3 votes)
SWAPS are designed to work only for similar notional values because the notional values are notional i.e they don't exchange hands. The simpler answer to your questions is companies don't really meet each other like explained here, this is done via financial intermediaries who handle swaps. Simplifying again but you can say these intermediaries make sure the notional amounts are same.(4 votes)
- Are these Interest Rate Swap transaction regulated by any financial or governmental entity?
And does this entity have any penalty power to prevent corruption?(1 vote)- Regulation in the OTC is still in it's infancy. There are some organizations that have some oversight. That may be changing with the Dodd-Frank legislation, but the specifics are still up in the air.
The CFTC (commodity futures trading commission) is the primary regulator of exchange traded derivatives products, so they will most likely have more authority in the OTC markets going forward. The CFTC is overseen by the senate agricultural committee, which is as weird as it sounds.
There's also the ISDA (International Swaps and Derivatives Association). They do a number of things, but are probably most well known for their work in the credit default swaps market. ISDA are the ones in charge of determining whether or not a credit event (default) has taken place.(3 votes)
- what is the advantage of using interest rate swap? i do not find any advantage. especially for firm one, now he has to pay more than before.(1 vote)
Company A may be dealing in more illiquid assets. Therefore, a fixed interest rate is better for company A because then it would know exactly how much cash it would need to pay interest. A fixed interest rate, even if it is higher on average, is still a lot safer. Company B, on the other hand, dealing in more liquid assets, doesn't need the safety that a fixed interest rate gives, so it prefers to just pay the variable rate, because on average it is lower.(2 votes)
- do parties entering into a swap contract always have the same amount borrowed. (deos the notional value has to the same for both parties)?(1 vote)
- Yes, otherwise it would be an extra loan on top of the swap.(2 votes)
I wonder if the companies deliberately make the contracts so that the interest rates are cleanly swapped with perfect effectiveness (like in this situation). It didn't look like it would match everything up at first, but Sal's calculations showed that everything netted out perfectly. Wow!(1 vote)
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.