1. Interest Rate Swap March 2011 Odie Pichappan Odie PichappanInterest Rate Swap1

2. Bird’s 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

3. Odie PichappanInterest Rate Swap3 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 3

4. Buyer ME Payer Seller SM Receiver 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. Fixed to Floating Floating to Fixed ForEx $ £ ¥ € Interest Rate Odie Pichappan4Interest Rate Swap Swap Terminologies Fixed Payment

5. Odie PichappanInterest Rate Swap5 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. 5

6. Odie PichappanInterest Rate Swap6 Comparative Advantage 6 Apple Inc wants to borrow at floating rate and Boeing Co wants to borrow at fixed rate, under following borrowing rates. 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. CounterpartyFLOATING RATEFIXED RATE APPLE INCLIBOR + 1.11%6.25% BOEING COLIBOR + 2.34%7.66% Difference1.23%1.41%

7. Odie PichappanInterest Rate Swap7 Comparative Advantage Calculation 7 Boeing Net 7.60% Apple Net L+1.05 6.25%LIBOR + 2.34% LIBOR 5.26%5.20% gained 6 bps Both counterparties gained 6 bps by borrowing in their preferred market where they have comparative advantage. Y = X =

8. Swap Spreads

9. Odie PichappanInterest Rate Swap9 Trading Swap Switch & Butterfly 9 Black dotted line is initial swap curve… Combination of top 2 curve trades makes butterfly strategy…

10. Trading Swap Spreads BOA Coupon Payments 3.42715 Swap Rate 3.54215 UBS Coupon Payments 2.19138 Swap Rate 2.39888 Pay Sell Repo Payments Cash Flow Diagram