Certificate for Introduction to Securities & Investment (Cert.ISI) Unit 1 Lesson 37:  Swaps  Interest rate swaps  Covered warrants 37cis

Swaps A swap is an agreement to exchange one set of cash-flows for another  Switching financing from one currency to another  Replacing floating rates of interest with fixed rates of interest The two exchanges of cash-flow are known as the “legs” of the swap

Swaps (cont’d) Swaps are negotiated between the parties to meet their specific requirements  The terms of each swap tends to be unique  Therefore the terms cannot be standardised and swaps cannot be traded on an exchange  Swaps are derivatives traded on an OTC basis The amounts to be exchanged are calculated by reference to a notional amount

Interest Rate Swaps Interest rate swaps are the most common form of swaps  One leg of the swap is payment of a fixed rate of interest  The other leg of the swap is payment of a floating rate of interest Interest rate swaps are usually used to hedge exposure to interest rate changes

Example of Interest Rate Swap Remember that banks are reluctant to lend money for long periods of time at fixed rates – usually companies have to accept loans with interest rates at a “spread” above the market rate, which varies Company A wishes to build and equip a major new manufacturing plant  The new plant is not expected to start producing any returns on investment for three years  Company A has to borrow money to cover construction and start-up costs The only offer of financing that Company A has been able to obtain is for a variable-rate loan  Company A estimates that the new manufacturing would be profitable at present rates of interest  Company A estimates that the project would become uneconomic if rates rose significantly within the three years How can Company A lock in its interest costs?

Example of Interest Rate Swap Company A could lock in its interest costs by entering into an interest rate swap with an investment bank In this case, the notional amount would be the amount that Company A has borrowed to finance the new manufacturing plant  Company A pays a fixed rate of interest to the investment bank  Investment bank pays a variable rate of interest back to Company A  The variable rate is usually based on Libor, plus a spread  The variable rate is usually reset quarterly If interest rates then do rise significantly, then Company A will be able to absorb the higher cost  Company A has hedged its interest rate exposure