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How To Design A Plain Vanilla Interest Rate Swap: Fixed Floating

This document provides an example of how to design a plain vanilla interest rate swap between two companies, Company A and Company B. It shows that with a financial intermediary acting as a counterparty, the swap can be constructed so that both companies receive a net gain of 0.4% compared to their alternative borrowing rates, and the intermediary receives a net gain of 0.1% per annum. The intermediary sets the rates paid and received, x and y, such that the gains to both companies are equal while providing its own 0.1% net gain. This makes the swap equally attractive to both companies while benefiting the intermediary.

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314 views3 pages

How To Design A Plain Vanilla Interest Rate Swap: Fixed Floating

This document provides an example of how to design a plain vanilla interest rate swap between two companies, Company A and Company B. It shows that with a financial intermediary acting as a counterparty, the swap can be constructed so that both companies receive a net gain of 0.4% compared to their alternative borrowing rates, and the intermediary receives a net gain of 0.1% per annum. The intermediary sets the rates paid and received, x and y, such that the gains to both companies are equal while providing its own 0.1% net gain. This makes the swap equally attractive to both companies while benefiting the intermediary.

Uploaded by

aS hausj
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

How to Design a plain vanilla Interest Rate Swap

An illustration of how to design a plain vanilla interest swap may best be illustrated by working through
the following exercise taken from John Hull's book “Futures, Options and Other Derivatives”

Companies A and B each seek a $20M 5-year loan:

A would like to obtain a floating-rate loan because their CFO feels that interest rates are headed
downwards and would like to benefit from any fall. They can borrow fixed at 12% and floating at LIBOR
plus .1%. B prefers a fixed-rate loan since their CFO feels that they should lock in a fixed rate now
since she feels that rates are headed upwards. B can borrow fixed at 13.4% and floating at LIBOR +
.6%.
Fixed Floating
Design a swap
Company A 12% LIBOR + 0.1% that will net a
Company B 13.4% LIBOR + 0.6% bank, acting as
intermediary,
0.1% per
annum and that
will appear
equally attractive to both companies.

We can calculate the relative gains between the fixed and floating markets for A vs B and hence we
have

fix fl
Δ = 13.4-12=1.4 Δ = (LIBOR + 0.6) – (LIBOR + 0.1)=0.5
fix fl
Comparative advantage gain = Δ - Δ = 1.4 - 0.5=0.9.

Thus we can see the following :

• A has a comparative advantage in both fixed and floating markets.

• A is more creditworthy than B.

We will consider 2 scenarios : i.) Without a financial intermediary ii.) With a financial
intermediary Let us first consider the case with no financial intermediary.

In the first case we might construct a swap with payments as below:

Company A
- Pay 12% to outside lender
- Pay LIBOR to B
- Receive 12% from B

Hence net rate of borrowing = (LIBOR + 12) – 12 = LIBOR If A borrowed directly, i.e. w/o the swap, its
rate would be LIBOR + 0.1% Hence A is better off by 0.1% for using the swap.
Company B

- Pay LIBOR + 0.6% to outside lender

- Pay 12% to A

- Receive LIBOR from A

Hence net rate of borrowing = LIBOR + 0.6+12 - LIBOR= 12.6% If B borrowed directly, i.e. w/o the

swap, its rate would be 13.4% Hence B is better off by 0.8% (=13.4-12.6) for using the swap. Thus we

can see that in the simple case above, net gain = 0.9 as predicted above, but company A would be

unhappy since B's gain is much higher.

We now consider the case with a financial intermediary.

In this case the design is not as simple. We have the following constraints:
• Net gain to financial intermediary is 0.1%. (i)

• Net gain to A must equal net gain to B since deal must be equally attractive to both companies.
We can construct a swap that is illustrated above. We need to find the values of x and y that will
satisfy the constraints imposed.

From constraint (i), we have for FI that Cash Inflow – Cash Outflow = 0.1 => (y+L)-(x+L)=0.1 => y-
x=0.1
(iii)

Gains from using Swap


We determine the net cash outflow, and hence gain from using swap over doing direct Gain (A) = Net
cash outflow – Cost of direct floating rate loan for A = [(L+12)-x] – [L+0.1]=11.9-x

Gain (B) = Net cash outflow – Cost of direct fixed rate loan for B
= [y+L+0.6-L]-13.4=y-12.8

To satisfy (ii), we must have Gain (A) = Gain (B) => 11.9-x = y -12.8 => y+x = 24.7 (iv)

We can then solve equations iii & iv simultaneously to get : 2x=24.8 => x=12.4 &

y=12.3 Thus the swap payments will be as follows:

Company A
• Pay 12% to outside lender

• Pay LIBOR to FI

• Receive 12.3% from FI

Hence net rate of borrowing for A: R = 12 + LIBOR -12.3=LIBOR-0.3% which is a gain of 0.4% over
A

borrowing directly without the swap.

Company B

• Pay LIBOR+0.6% to outside lender


• Pay 12.4% to FI
• Receive LIBOR from FI

Hence net rate of borrowing for B: R = LIBOR + 0.6+12.4-LIBOR = 13% which is a gain of 0.4%
B

over borrowing directly without the swap.

Financial intermediary

• Pay x=12.3% to A
• Receive y = 12.4% from B
• Receive LIBOR from A
• Pay LIBOR to B Hence net gain = 12.4-12.3+LIBOR - LIBOR=0.1%

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