STOCK GYAN. (Part 5 – Interest Rate Swaps)

STOCK GYAN. (Part 5 – Interest Rate Swaps)

Hello Readers,

Hope you had read the previous parts of Stock Gyan series, if not then click on the below links:

Part 1: Basics

Part 2: Bonds

Part 3: Loans

Part 4: Bond Futures & Option on Bond futures

We were discussing about Long term Debt Asset class under which we had discussed about the above 4 grandchilds.

Don’t get confused. Let me remind you this hierarchy again.

In relation to our today’s topic:

  • The parent name is Long Term Debt
  • The child name is OTC derivatives
  • The grandchild names are Interest rate swaps, Interest rate caps and floors, Interest rate options and Exotic derivatives

In this part, we will discuss about the further categories of Long term debt asset class.

Now, the 4th child of Long term debt asset class is  OTC Derivatives.

This OTC Derivatives includes Interest rate swaps, Interest rate caps and floors, Interest rate options and Exotic derivatives.

(you can also see the table in the 1st part of the Stock Gyan series for better understanding).

First of all understand the meaning of OTC Derivatives:

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary.

Let’s begin with our topic: we will discuss about the 1st category of OTC Derivatives in detail i.e. Interest Rate Swaps in this part.

Meaning of Interest Rate Swap:

An interest rate swap is a contractual agreement between two parties to exchange interest payments.

Please Note: Under the Interest Rate Swap, the parties never exchange the principal amounts. On the payment date, it is only the difference between the fixed and variable interest amounts that is paid; there is no exchange of the full interest amounts.

You will come to know the concept in detail as soon as you will go through the types of Interest rate swap.

Types of Interest Rate Swap:

  1. Floating-for-fixed rate swap
  2. Fixed-for-floating rate swap
  3. Fixed-for-fixed rate swap
  4. Floating-for-floating rate swap

Let’s discuss each of them in detail with examples:

Before proceeding, note one point that the Floating rate is generally taken as London Interbank Offered Rate which is also known a LIBOR.

LIBOR: It serves as the first step to calculating interest rates on various loans throughout the world.

Floating-for-fixed rate swap

An agreement whereby an issuer synthetically converts variable rate debt to fixed rate debt through an interest rate swap or similar arrangement.

For example: Atul owns a Rs. 1,00,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Atul receives changes.

Also, you own a Rs. 1,00,000 investment that pays you 1.5% every month. The payment you receives never changes as the interest rate is fixed.

Atul decides that that he would rather opt for a constant payment and on the other side you decides that you would rather take a chance on receiving higher payments. So you and atul agree to enter into an interest rate swap contract.

Take the rate of LIBOR as 1%

Now see what will happen:

Atul will receive a monthly payment of Rs. 2000 on his investment i.e. 1,00,000(1% + 1%)

And on the other side, you will receive a monthly payment of Rs.  1500 on your investment i.e. 1,00,000(1.5%)

Now, as per the contract, Atul have to pay Rs. 2000 to you and in return you have to pay Rs. 1500 to Atul. So, finally Atul have to pay Rs. 500 to you.

 

Fixed-for-floating rate swap

Fixed-for-floating swap is an arrangement between two parties (counterparties), in which one party pays a fixed rate, while the other pays a floating rate.

Just reverse the above example and you will easily understand the concept. Let me do this for you.

For example: Atul owns a Rs. 1,00,000 investment that pays him 1% every month. The payment atul receives never changes as the interest rate is fixed

Also, you own a Rs. 1,00,000 investment that pays you LIBOR + 1.5% every month. As LIBOR goes up and down, the payment you  receives changes.

Atul decides that that he would rather opt for a variable payment and take a chance on receiving higher payments and on the other side you decides that you would rather opt for fixed payments. So you and atul agree to enter into an interest rate swap contract.

Take the rate of LIBOR as 1%

Now see what will happen:

Atul will receive a monthly payment of Rs. 1000 on his investment i.e. 1,00,000 (1%)

And on the other side, you will receive a monthly payment of Rs.  2500 on your investment i.e. 1,00,000 (1+1.5%)

Now, as per the contract, Atul have to pay Rs. 1000 to you and in return you have to pay Rs. 2500 to Atul. So, finally you have to pay Rs. 1500 to Atul.

Fixed-for-fixed rate swap

This is a contractual arrangement under which one party agrees to pay fixed interest rate and the other party also agrees on the same but there can be different scenarios.

They may enter into fixed rate swap for different currencies like Rupee to USD or vice versa

They may enter into fixed rate swap for same currency but with different tenors (duration). For example: You pay Rupee quarterly interest to receive Rupee semi-annually interest.

(EURIBOR: The Euro Interbank Offered Rate (Euribor) is a daily reference rate, published by the European Money Markets Institute, based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market or interbank market).

Let’s take an example:

Different currencies:

Suppose Atul and You entered into a contract for fixed rate swap where atul will pay you fixed interest rate on Rupee and You will pay atul fixed interest rate on USD.

If Atul has Rs. 1,00,000 investments at 10% interest rate and you have $10,000 investments at 5% investments then the scenario will be as follows:

Atul will receive an interest of Rs. 10,000 (1,00,000*10%) on his investment and you will receive $500 (10,000*5%) on your investment.

Take the Rupee – Dollar rate as Rs. 65 for 1 Dollar.

The result will be: Atul has to pay Rs. 10000 to you and you have to pay Rs.  32500 to him ($500*65). So, ultimately you have to pay Rs. 22500  $346.15 (22500/65) to Atul.

 Same Currency:

Suppose Atul and You entered into a contract for fixed rate swap where atul will pay you fixed interest rate on 6 monthly investments of Rs. 1,00,000  at 10% interest and You will pay atul fixed interest rate on quarterly investments of Rs. 1,00,000  at 8% interest.

Atul will receive an interest of Rs. 5,000 (1,00,000*10%*6/12) on his investment and you will receive Rs. 2000 (1,00,000*8%*1/4) on your investment.

The result will be: Atul has to pay Rs. 5000 to you and you have to pay Rs. 2000 to him ($500*65). So, ultimately Atul have to pay Rs. 3000 to you.

Floating-for-floating rate swap

This is a contractual arrangement under which one party agrees to pay floating interest rate and the other party also agrees on the same but there can be different scenarios.

They may enter into floating rate swap for different currencies like LIBOR to EURIBOR or vice versa.

(EURIBOR: The Euro Interbank Offered Rate (Euribor) is a daily reference rate, published by the European Money Markets Institute, based on the averaged interest rates at which Eurozone banks offer to lend unsecured funds to other banks in the euro wholesale money market or interbank market).

They may enter into floating rate swap for same currency but with different tenors (duration). For example: You pay LIBOR quarterly interest to receive LIBOR semi-annually interest.

Let’s take an example:

Different Currencies:

Atul own  $1,00,000 LIBOR investments which pay him LIBOR + 1% interest rate and you own Euro 1,00,000  EURIBOR investment that pays you EURIBOR + 1.5% every month. As LIBOR and EURIBOR goes up and down, the payment you receives changes.

Take the rate of LIBOR as 1% and EURIBOR as 1.5%

Now see what will happen:

Atul will receive a monthly payment of $2000 on his investment i.e. 1,00,000(1% + 1%)

And on the other side, you will receive a monthly payment of EURO 3000 on your investment i.e. 1,00,000(1.5% + 1.5%)

Take the rate of 1 EURO = $5

Now, as per the contract, Atul have to pay $2000 to you and in return you have to pay EURO 3000 or 15000 (3000*5) to Atul. So, finally you have to pay $13000 to Atul.

Same Currency:

Suppose Atul and You entered into a contract for floating rate swap where atul will pay you floating interest rate on 6 monthly investments of Rs. 1,00,000  at LIBOR + 1% interest and You will pay atul floating interest rate on quarterly investments of Rs. 1,00,000  at LIBOR + 2% interest.

Take the rate of LIBOR as 1%

Atul will receive an interest (interest rate: 1 + 1 = 2%) of Rs. 1,000 (1,00,000*2%*6/12)  on his investment and you will receive an interest (interest rate: 1 + 2 = 3%) of  Rs. 750 (1,00,000*3%*1/4) on your investment.

The result will be: Atul has to pay Rs. 1000 to you and you have to pay Rs. 750 to him. So, ultimately Atul have to pay Rs. 250 to you.

This all was about Interest Rate Swaps

In the next part we will discuss about

  • Interest rate caps and floors
  • Interest rate options
  • Exotic derivatives

So, don’t miss it.

Share this useful info with your friends and stay tuned to this website for more parts.

In case of any query related to above article, the questions can be asked by commenting in the comment box or the author can be contacted personally at info@atulkhurana.com

P.S. – We at atulkhurana.com don’t deal in services related to share or stocks investment advises. So, kindly don’t ask any query related to same.

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