Interest Rate Swaps
The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the market where they have comparative advantage. However, this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.
Read more about this topic: Swap (finance), Types of Swaps
Famous quotes containing the words interest, rate and/or swaps:
“Wherever there is interest and power to do wrong, wrong will generally be done.”
—James Madison (1751–1836)
““Terence, this is stupid stuff:
You eat your victuals fast enough;
There can’t be much amiss, ‘tis clear,
To see the rate you drink your beer.”
—A.E. (Alfred Edward)
“When you got to the table you couldn’t go right to eating, but you had to wait for the widow to tuck down her head and grumble a little over the victuals, though there warn’t really anything the matter with them. That is, nothing only everything was cooked by itself. In a barrel of odds and ends it is different; things get mixed up, and the juice kind of swaps around, and the things go better.”
—Mark Twain [Samuel Langhorne Clemens] (1835–1910)