Can someone give me a general overview of interest rate swaps?
I'm trying to learn about interest rate swaps in my internship currently, but because I've never really had experience with trading, bonds, etc., I'm getting confused with just trying to read powerpoints and information on websites.
All I'm really understanding is that interest rate swaps occur between two counterparties who agree to exchange payments based on an agreed-upon principle amount and that lasts for a fixed period of time.
My main questions (though I would def. appreciate it if someone can give an overall explanation) are:
1) How exactly do floating interest rates and fixed interest rates tie into all this? How do the payments go from being a floating-rate payment to a fixed payment and vice-versa?
2) I read that interest rate swaps don't generate new sources of funding. How then do the counterparties make money?
2.5) I'm sort of guessing that the counterparties are making money because the money that they receive from each other accumulate interest. Does this just mean that the counterparties are taking the money they receive, investing it, and then taking it out again when it comes time to exchange payments again?
3) What exactly is the reason for counterparties to engage in interest rate swaps? Why not just invest the money and accumulate your own interest?
Sorry if these are questions that should have obvious answers; I (obviously) don't have a very strong financial background back at school, so I'm trying to catch up so I don't fall behind in this internship...
There are actually some decent videos on youtube that describe (visually even) the basics of IR swaps.
http://www.investopedia.com/articles/optioninvestor/07/swaps.asp
Read the links posted above, and http://www.investopedia.com/ask/answers/06/benefitsofswaps.asp.
But in my words:
1) It's precisely what it's exchanged. One of the parties pays a fixed interest and receives a floating one. For the other party it's viceversa, obviously. They go from fixed to floating through the IRS. Let's say I have a bond that pays 10k a year. I buy an IRS so I pay those 10k and I receive LIBOR+2%. So what I've done is transform my fixed 10k into a floating cash flow.
2 and 3) You make money by hedging against fluctuations in interest rates or profiting from them. Again, if you think IR are going down, you enter the swap above and receive 10k fixed, so if the LIBOR goes down you're profiting. At the same time, if IR are going down, your debt might be going down (depends on the structure), but since your income isn't because its fixed after the IRS, you're profiting.
if you want it in detail read Hull
I know this thread is from a while back, but I just have a couple questions about Swaps:
1) What is the future of the market in the face of all this regulation? Is it all going to exchanges and what is that going to mean for BB swaps traders?
2) Probably a stupid question--but say you are at one of the top players in Rates (Barcap, JPM, GS etc), would swaps trading be a good place to be? meaning -- is swaps trading a big money maker and traders on those desks would be then compensated for that.
1) Exchange clearing doesn't change anything fundamentally, so it means, at worst, more annoyances and admin, as well as higher margin requirements.
2) Yes.
My Z$2c...
Ok thanks! But as for the exchange clearing, wouldn't that make them less profitable because they wouldn't be able to be tailored to individual clients-- more commoditized so lower revenues for banks?
the textbook answer would be that interest rate swaps often occur when there's comparative advantage.
Company A can borrow at Libor +.2 or fixed at 5% Company B can borrow at Libor +.5 or fixed at 6%
Company A has a comparative advantage borrowing fixed because there's a bigger difference in their fixed rate compared to Company B (A can borrow at 1% less). Company B has a comparative advantage in borrowing floating because the difference in floating is only .3 vs 1% for fixed.
For the swap to work, company A must borrow fixed (comparative advantage) and want to swap it to floating. The swap would then be able to save each company .35% over the liability where they don't have comparative advantage.
Company A borrows fixed 5%. It pays LIBOR to B. Company B borrows Libor +.5. It pays fixed 5.15% to A.
Net, A owes 5% to the bank where it borrowed from, receives 5.15%, and pays LIBOR. In the end, it effectively borrows at LIBOR - .15%....which represents a .35% saving. (LIBOR +.2% originally, now LIBOR - .15%)
Net, B owes LIBOR + .5% to the bank it borrowed from, receives LIBOR, and pays 5.15% to A. In the end, it borrows 5.65% FIXED or a .35% saving over what it would have without a swap.
Huh? Comparative advantage? What's next? You gonna use Porter's friggin' five forces to explain swap curve dynamics? I can't wait...
What a bunch of bollox...
Notice I said TEXTBOOK. Since someone quoted Hull, I translated his main argument since I've got the Hull TEXTBOOK in response to the OP's first question. This is why I didn't say 'in practice', because theory often differs from practice... It would appear your reading comprehension is 'bollox'.
Hull is, indeed, hopelessly outdated in terms of practice, hence my comment.
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