This is how I like to think about it…
You go out and buy a brand new Cayman S and finance it by borrowing from the bank at 4%. However your portfolio earns a variable rate (for simplicity purposes) of LIBOR +2%, now being all finance savvy you want to hedge the risk of cash flow mismatch. You earn at a floating rate and have an obligation at a fixed rate.
Therefore you go out and enter into a swap agreement to pay LIBOR +2% and receive 4%. This way you can rest assure that you can meet the 4% payment that financed your beautiful car and you pay what you earn from you portfolio.
Enjoy the car 😀
Both explanations from @reena and @diya look good to me! Basically the concept is one of these two situations:
- you have a fixed interest rate liability, and you want to swap it for a floating interest rate liability
- or you have a floating interest rate liability, and you want to swap it for a fixed interest rate liability
Which you prefer normally depends (in real life) on the nature of your business and/or financing structure. In the exam, it’s normally stated in the question! 🙂
Ok, I’ll give it a go.
An interest rate swap is a contractual agreement between two parties to exchange
cash flows at predetermined intervals for a specified period.
Let’s go with a simple vanilla interest rate swap as example, where there is an agreement to exchange fixed interest payments for floating interest payments.
If Company A has floating rate debt of LIBOR + 2%, but it’s assets are earning 3% in fixed deposit. For liability management purposes, Company A wants more certainty that it can cover it’s cost of debt in the future.
So it can choose to hedge against this interest rate risk by paying a fixed payment (3%) to a swap dealer, and receiving floating rate in return (for example LIBOR + 1%).
This way, Company A managed to fixed it’s rate of debt to 4% (the net effect of paying 3%, receiving LIBOR + 1%, paying LIBOR + 2%).
Does this make sense?
Or a version from a someone with no financial background:
You took up a mortgage to buy a house at the interest rate of say 4%.
Of course if your mortgage rate drops, you would pay less but if it increases you will have your monthly repayment at the new rate. To ensure you are not exposed to the risk of a higher interest rate, you would protect (hedge) yourself by buying a interest rate cap (your interest rate would be ‘capped’ at that rate but the theory behind it is you are actually doing a interest rate swap, you pay the dealer a fixed rate and he pays you a floating rate).
Your Mortgage <--- floating rate --- YOU <--- floating rate --- Dealer YOU –fixed rate –> Dealer
As a result, doesn’t matter how high the rate goes you are still paying a fixed rate of 4% .
Of course, by doing this you would not enjoy the benefit when the floating rate decreases (but that’s where the interest rate floor comes in).
Hope that helps. 😀
When i read all the explanations the first time, honestly, i didn’t understand. But reading all of ’em as a series of explanation thrice, i understood. Thank you once again everyone! I did not realize that most of my doubts would come from derivatives, but that need to understand is so darn stubborn!
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