Interest Rate

Swap
March 2011

Odie Pichappan

Odie Pichappan

Interest Rate Swap

Birds Eye
View
What is Swap?
Different Types
Benefits
Swap Terminologies
Comparative Advantage
Simple Calculation with Example
Trading Swap Spreads
Graph
Trading Swap Switch & Butterfly
Buying and selling Swap Spreads

What is
Swap?
Swap is an agreement between two parties, called
Counterparties, who exchange future cash flows over a
period of time based on market conditions.
Interest Rate Swaps
Commodity Swap
Currency Swaps and more

Mortgage servicer would like to transform their fixed

rate assets to floating rate assets
Commodity producer wishes to fix his income and
would agree to pay the market price to a financial
institution, in return for receiving fixed payments for
the commodity
Mitigate Price Risk
Lower Progressive Tax
Odie Pichappan

Interest Rate Swap

Swap
Terminologies
ForEx
$
Floating
to Fixed

Interest
Rate

Buyer

Seller

Payer

SM
Receiver

ME

Fixed
to
Floati
ng

Fixed
Payment

Buyer - Counterparty that receives floating/variable cash flow

(Long Swap)
Payer - Counterparty that pays fixed rate.
Seller - Counterparty that is paying floating/variable cash flow
(Short Swap)
Receiver - Counterparty that receives fixed rate.
Odie Pichappan

Interest Rate Swap

Swap
Terminologies
Notional principal amount on which the periodic
payment of cash flow is calculated.
Payment period interest calculation period and
cash exchanged at the end of the period.
Day count convention (Yield basis) determines
how interest accrues over time period (Actual/360
float, 30/360 fixed).
Rate fixing (Rate Reset) normally done 2 days
before start of period.
ISDA - International Swaps and Derivatives
Association, trade organization of participants in
the market for over-the-counter derivatives.
Tenor Maturity of the swap in years.
Odie Pichappan

Interest Rate Swap

Comparative
Advantage
Apple Inc wants to borrow at floating rate and
Boeing Co wants to borrow at fixed rate, under
following
borrowing rates.
Counterparty
FLOATING
FIXED RATE
RATE
APPLE INC

LIBOR + 1.11%

6.25%

BOEING CO

LIBOR + 2.34%

7.66%

Difference

1.23%

1.41%

Apple has relative advantage in fixed market and

Boeing has relative advantage in floating market.
The total arbitrage gain by entering into a swap
deal would be 1.41% - 1.23% = 0.18%
Design a swap where the gain are equally shared
between the 2 companies and the swap dealer.
Odie Pichappan

Interest Rate Swap

Comparative Advantage
Calculation
gained 6 bps

gained 6 bps
LIBOR

gained 6 bps
LIBOR

Boeing

Apple

Net 7.60%

Net L+1.05

Y = 5.26%

X = 5.20%

LIBOR + 2.34%

6.25%

Both counterparties gained 6 bps by borrowing

in their preferred market where they have
comparative advantage.
Odie Pichappan

Interest Rate Swap

Swap
Spreads

Trading Swap Switch &

Butterfly

Black dotted line is

initial swap curve
Combination of top 2
curve trades makes
butterfly strategy

Odie Pichappan

Interest Rate Swap

Trading Swap
Spreads

Cash Flow Diagram

Coupon
Payments
3.42715

BOA
Swap Rate
3.54215

Sell
Repo
Payments

Coupon
Payments
2.19138

Repo
Payments

UBS
Pay

Swap
Rate
2.39888