Interest Rate Swap

The speaker provides an in-depth explanation of how an interest rate swap can turn a floating rate obligation into a fixed-rate one.  Interest rate swaps are done through a financial intermediary who takes a few basis points for performing the swap on behalf of the two counterparties.  It is important to note that in a plain vanilla swap, notional is not exchanged between the two counterparties; just the interest rate differential within the swap. 

Essentially, a company which has issued debt at a fixed rate may want to trade interest rate structures with another company which has their desired interest rate structure.  For example, company A might be paying 5.5% on their debt and believe that a variable rate structure would allow them to pay a lower rate based on their expectations that rates will fall.  Company B may be paying LIBOR plus 20 bps on their debt and believe that rates will climb; therefore seeking a fixed rate structure.  In this simplistic example, company A will pay a negotiated rate to company B at LIBOR plus 5 while Company B will pay a fixed rate, such as 5.25 to company A.  In essence, they have traded interest structures.

Assuming that the financial intermediary takes 3 basis points to manage the swap, company A will be effectively paying 5.5 - 5.25 + Libor + 5bps which would equal LIBOR + 30.  Company B would effectively be paying:  Libor + 20bps - (Libor + 5bps) + 5.25% = 5.40%
Tim Ord
Ord Oracle

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