Page 126 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 9: Swaps

amount against which the interest is calculated. No principal ever changes hands. Maturities Notes
range from less than a year to more than 15 years; however, most transactions fall within a
2-year to 10-year period.

Example: Companies A & B have been offered the following rates per annum on a $20
million five-year plan.
Fixed Rate Floating Rate
Company A 5% LIBOR+0.5%

Company B 6.5% LIBOR+1.0%
Company A requires a floating rate loan; Company B requires a fixed rate loan. Design a swap
that will net a bank; acting as intermediary, 40 basis points per annum and that will appear
equally attractive to both companies.
Solution:
Company 'A' requires floating rate loan. Where as Company 'B' requires fixed rate loan.

But in reality;
Company A has an advantage in fixed rate as well as in floating rate.
But in fixed rate advantage =(6.5 – 5)%=1.5%
In floating rate advantage= (LIBOR + 1 – LIBOR – 0.5)% = 0.5%

So, Company A has comparative advantage in fixed rate.
For this, "A" searches for a counter party, who has a comparative advantage in floating rate, that
is only possible through an intermediary (banks) than only swap deal occurs.

Before the deal, Company "A" paid floating rate interest LIBOR+0.5%
But after the deal, paid by company LIBOR+0.2%
So, total gain =>LIBOR+0.5% - LIBOR - 0.2%=0.3%
Before the deal Company B paid fixed rate interest 6.5%
But after the deal, interest paid by company 6.2%

So, total gain =>6.5% - 6.2%=0.3%
For the bank, gain in fixed rate=>(6.2 - 5)%=1.2%
Gain in floating rate=>LIBOR+0.2% - LIBOR - 1%=(-)0.8%

Total Gain of Bank=1.2% - 0.8%=0.4%

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