Appendix IV Technical Note on Interest Rate and Currency Swaps

Donald Mathieson, Eliot Kalter, Maxwell Watson, and G. Kincaid
Published Date:
February 1986
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Interest Rate Swap

The typical interest rate swap is designed to arbitrage the different abilities of two borrowers (counterparties) to gain access to the fixed and floating interest rate markets. One counterparty generally has access to floating interest rate debt at relatively attractive rates but wants instead to secure fixed interest rate funds. The other counterparty has good access to the fixed interest rate markets but would prefer to have floating interest rate debt.

For example, the counterparty issuing fixed interest rate debt may be an AAA-rated corporation; while the counterparty supplying floating interest rate debt is an A-rated corporation (Figure I). The AAA corporation may be able to issue a fixed interest rate bond carrying a 12 percent yield, whereas the A corporation would have to pay 14 percent (an interest rate differential of 2 percent). In contrast, the AAA corporation may be able to borrow in the floating interest rate market at the London Interbank Offered Rate (LIBOR) plus ¼ percent, whereas the A corporation could obtain a loan at LIBOR plus ½ percent (an interest rate differential of minus ¼ percent). The combined interest rate differential (2 percent minus ¼ percent = ¾ percent) represents the potential arbitrage gain that the corporations could share through a swap of obligations. The A corporation would be interested in undertaking a swap if it can obtain fixed interest rate funding at less than 14 percent, whereas the AAA corporation would engage in the swap only if it obtains floating interest rate funds at less than LIBOR plus ½ percent.


Exactly how the differential is shared between the two corporations is determined by negotiations. One possibility would be for the swap to be arranged so that the A corporation obtains fixed interest rate funds at 13¼ percent, whereas the AAA corporation would obtain floating rate funding at LIBOR minus ¾ percent. The cumulative benefit for both counterparties equals the initial 1¾ percent interest rate differential. To achieve this situation, the A corporation would agree to service not only the 12 percent cost of the AAA corporation’s fixed interest rate debt but also to pay 1¼ percent towards the cost of servicing the LIBOR plus ½ percent floating interest rate debt that it had raised.

Currency Swaps

A typical currency swap is illustrated in Figure 2. In this situation. Company I has an outstanding deutsche mark bond which it is willing to swap into an equivalent U.S. dollar liability. Assume Company 2 plans to issue new fixed interest rate U.S. dollar bonds (a market in which it has access to credit at relatively good terms) and to swap the proceeds into deutsche marks (a market where it does not have very good access to credit at a relatively attractive cost). Initially, Company 1 would sell deutsche marks to Company 2 in exchange for U.S. dollars. Over the life of the swap arrangement, the two companies would then agree to provide the amounts of U.S. dollars or deutsche marks needed to service the other party’s servicing payments. At the end of the swap period, the two companies would reverse the initial transaction at a prearranged exchange rate.


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