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Questions and Answers
In an interest rate swap between Company A and Company B, where Company A has a fixed rate of 7.0% and Company B has a fixed rate of 8.5%, how are the net savings typically determined?
In an interest rate swap between Company A and Company B, where Company A has a fixed rate of 7.0% and Company B has a fixed rate of 8.5%, how are the net savings typically determined?
- By averaging the individual fixed rates of both companies.
- By adding Company A's and Company B's fixed rates together.
- By subtracting Company A's fixed rate from Company B's fixed rate. (correct)
- By calculating the difference between their floating rates.
What primary benefit does a company derive from engaging in an interest rate swap?
What primary benefit does a company derive from engaging in an interest rate swap?
- Increasing their overall debt.
- Eliminating all interest rate risk.
- Avoiding the need to take out a loan.
- Gaining access to a lower rate on the type of loan they require. (correct)
In the context of an interest rate swap, what role does a bank play when it acts as an intermediary?
In the context of an interest rate swap, what role does a bank play when it acts as an intermediary?
- The bank assumes all of the risk of the swap.
- The bank facilitates the swap and takes a portion of the savings as a fee. (correct)
- The bank determines the interest rates for the swap.
- The bank facilitates the swap for a fee, without assuming risk.
When a bank acts as an intermediary in an interest rate swap, how is its fee typically covered?
When a bank acts as an intermediary in an interest rate swap, how is its fee typically covered?
In the example provided, if Company A pays LIB – 0.45% to the bank and Company B pays 8.05% to the bank, what does the bank do with these payments?
In the example provided, if Company A pays LIB – 0.45% to the bank and Company B pays 8.05% to the bank, what does the bank do with these payments?
What is the primary risk that companies face when entering a currency swap?
What is the primary risk that companies face when entering a currency swap?
In a currency swap, what is the role of a financial institution regarding exchange rate risk?
In a currency swap, what is the role of a financial institution regarding exchange rate risk?
If Company X wishes to borrow U.S. dollars and Company Y wishes to borrow Japanese Yen, what type of swap would be most appropriate?
If Company X wishes to borrow U.S. dollars and Company Y wishes to borrow Japanese Yen, what type of swap would be most appropriate?
In a typical currency swap involving a bank as an intermediary, how are the net savings shared between the companies and the bank?
In a typical currency swap involving a bank as an intermediary, how are the net savings shared between the companies and the bank?
What is a 'notional principal' in the context of a swap agreement?
What is a 'notional principal' in the context of a swap agreement?
Company A has been offered a fixed rate of 7.0% and Company B has been offered a fixed rate of 8.5%. If they enter into an interest rate swap that is equally attractive to both, how much lower will each party's rate be compared to what they would pay without the swap?
Company A has been offered a fixed rate of 7.0% and Company B has been offered a fixed rate of 8.5%. If they enter into an interest rate swap that is equally attractive to both, how much lower will each party's rate be compared to what they would pay without the swap?
Company Y wishes to borrow Yen at 6.5% and Company X wishes to borrow Dollars at 9.6%. If the bank takes a 0.5% fee as an intermediary, what is the amount of savings to be shared equally between Company X and Company Y?
Company Y wishes to borrow Yen at 6.5% and Company X wishes to borrow Dollars at 9.6%. If the bank takes a 0.5% fee as an intermediary, what is the amount of savings to be shared equally between Company X and Company Y?
What is the first main step with determining the savings for a currency swap?
What is the first main step with determining the savings for a currency swap?
In the first example regarding the interest rate swap, which company requires a floating-rate loan?
In the first example regarding the interest rate swap, which company requires a floating-rate loan?
Company A is offered a fixed-rate of 7.0% and a floating rate of LIB. Company B is offered a fixed rate of 8.5% and LIB + 0.5%. Company B requires a fixed-rate loan. If they engage in a swap without a bank intermediary, which fixed rate does Company B pay to Company A?
Company A is offered a fixed-rate of 7.0% and a floating rate of LIB. Company B is offered a fixed rate of 8.5% and LIB + 0.5%. Company B requires a fixed-rate loan. If they engage in a swap without a bank intermediary, which fixed rate does Company B pay to Company A?
Company A is offered a fixed rate of 7.0%, and Company B is offered a rate of LIB + 0.5%. If the diagram provided is followed, which entity pays Company B?
Company A is offered a fixed rate of 7.0%, and Company B is offered a rate of LIB + 0.5%. If the diagram provided is followed, which entity pays Company B?
In a currency swap, the interest payments are denominated in what?
In a currency swap, the interest payments are denominated in what?
What is the rate Company Y pays to company X after a swap with the following rates: Company Y - 6.5% Yen, Company X - 9.6% Dollar. The split is equal, and does not include the bank.
What is the rate Company Y pays to company X after a swap with the following rates: Company Y - 6.5% Yen, Company X - 9.6% Dollar. The split is equal, and does not include the bank.
Per diagram 2 in the currency swap, what percentage does Company X end up paying?
Per diagram 2 in the currency swap, what percentage does Company X end up paying?
In the currency swap, which risk is assumed primarily by the financial instution?
In the currency swap, which risk is assumed primarily by the financial instution?
Flashcards
What is a swap?
What is a swap?
An agreement where two parties exchange cash flows based on different interest rates or currencies.
How does an interest rate swap work?
How does an interest rate swap work?
Company B pays Company A a fixed rate, while Company A pays Company B a floating rate, allowing each to pay a rate lower than without the swap.
What are the net savings in a swap?
What are the net savings in a swap?
Net savings shared equally from the difference between fixed and floating rates.
What is a currency swap?
What is a currency swap?
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What risk do companies bear in currency swaps?
What risk do companies bear in currency swaps?
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What is the 'spread' in currency swaps?
What is the 'spread' in currency swaps?
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Who typically assumes exchange rate risk?
Who typically assumes exchange rate risk?
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What is the role of an intermediary in a swap?
What is the role of an intermediary in a swap?
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Study Notes
- Companies A and B are offered interest rates for a 5-year loan, where Company B needs a fixed rate and Company A needs a floating rate.
Interest Rate Swap Design
- Objective: Design a swap equally attractive to both companies.
- Objective: Design a swap netting a bank a 0.1% annual fee, while remaining attractive to both companies.
- Company B pays LIB + 0.5% and Company A pays LIB without the swap.
- Company A takes the 7% fixed rate loan (1.5% less than 8.5%), and Company B takes the LIB + 0.5% floating rate loan (0.5% higher than LIB).
Savings
- Net savings amount to 1.5% - 0.5% = 1% for both parties.
- Savings reduce each party's rate by 0.5% on their required loan type.
- Company B pays Company A the 8% fixed rate, and Company A pays Company B the floating rate of LIB - 0.5%.
- Each company pays 0.5% less than without the swap.
Intermediary Bank
- A bank acts as an intermediary for a 0.1% fee from the 1% net savings (the spread).
- The shared savings are now 1% - 0.1% = 0.9%, split as 0.45% for each company.
- Company B pays 8.5% - 0.45% = 8.05%.
- Company A pays LIB – 0.45%.
Bank's Role
- Both payments go to the bank, which pays each party to offset their loan.
- The bank receives 8.05% + LIB – 0.45% = LIB + 7.6% and pays 7% + LIB + 0.5% = LIB + 7.5%.
- The bank's fee is the difference: (LIB + 7.6%) – (LIB + 7.5%) = 0.1%.
Currency Swap Scenario
- Company X wants to borrow U.S. dollars and Company Y wants to borrow Japanese Yen at fixed rates.
- Company Y is quoted at 6.5% for Yen, and Company X is quoted at 5.0% for Yen.
- Company Y is quoted at 10% for Dollars, and Company X is quoted at 9.6% for Dollars.
Currency Swap Objective
- Design a swap equally attractive for both companies, or with a bank intermediary taking a 0.5% annual fee.
- In this scenario companies face exchange rate risks because their interest payments are in different currencies.
- The bank assumes the exchange rate risk when acting as an intermediary.
Determining Net Savings
- The net saving (spread) is 1.5% (Yen) - 0.4% (Dollar) = 1.1%.
- The split is 0.55% for Company X and 0.55% for Company Y.
- Company Y pays Yen 5.95% to Company X, calculated as 6.5% - 0.55%.
- Company X pays 9.05% to Company Y, calculated as 9.6% - 0.55%.
- Company Y pays 5.95% to Company X, allocates 5% for Company X's loan payment.
- It allocates the remaining Yen 0.95% plus 9.05% for its 10% loan payment.
Fees
- The bank fee is 0.5%, leaving a net saving of 1.1% - 0.5% = 0.6%.
- The split is 0.3% for Company X and 0.3% for Company Y.
- Company Y pays 6.5% - 0.3% = 6.2% Yen.
- Company X pays 9.6% - 0.3% = $9.3% which are paid to the bank.
- The bank pays what each party needs to pay off its loan.
- The bank receives 6.2% Yen + $9.3% and pays 5% Yen + $10%.
- It is left with Yen 1.2% - $0.7%, which equals its 0.5% fee, subject to the Yen - $ exchange rate risk.
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