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hie, can you help how to work out out an interest rate swap,i just dont understand the calculations involved esp the two questions highlighted above and how they were solved.
Rgds,
Andrew.
In the June 2014 exam, CMC can borrow at a fixed 2.2% or a floating Y + 0.4%
The way a swap works is that they find a counterparty (CP) who borrow ‘the opposite’ of them (i.e. if CMC borrows floating then the CP borrows fixed, and vice versa). The CP in this question can borrow fixed at 3.8% or floating at Y + 0.8%.
So….if CMC were to borrow floating and the CP were to borrow fixed, then in total they will be paying Y + 0.4% + 3.8% = Y + 4.2%
On the other hand, if CMC were to borrow fixed and CP were to borrow floating, then in the total they will be paying 2.2% + Y + 0.8% = Y + 3%
So……between them they would save 1.2% – i.e. 0.6% each. They would both have to pay 0.2% in fees but they would still end up making a saving of 0.4% each.
They will only get this saving by borrowing and effectively paying each others interest.
So….if CMC had borrowing floating themselves they would have to pay L + 0.4%. Swapping will save 0.4% and they will end up paying only L
If CP had borrowed fixed themselves they would have to pay 3.8%. Swapping will save them 0.4% and they will end up paying only 3.4%.The way they will actually achieve this end result is as follows (although this final bit was not required in the exam):
CMC will borrow fixed and pay 2.2%.
They will pay the fee of 0.2% to the bank.
They will pay L to CP and CP will pay 2.4% to CMC (this is the swap bit).
Net result means they end up paying 2.2% + 0.2% + L – 2.4% = LCP will borrow floating at pay L + 0.8%
They will pay the fee of 0.2% to the bank,
They will pay 2.4% to CMC and receive L from CMC (this again is the swap bit).
Net result means they end up paying L + 0.8% + 0.2% + 2.4% – L = 3.4%I hope that helps a bit!
(The fact that it was asked in June does actually make it unlikely that it will be asked again in December.)
Thanks i appreciate,yeah i am just trying to be thorough and leave no stone unturned.
Please help me, as your explanation above, the characteristic of IR swap is
1,CMC would pay 2.2% to the bank
CP would pay L + 0.8% to the bankCMC use L + 0.4% to exchange for Fixed rate 3.8% and see whether the exchange is gain or loss. Is it right?
2, About counter party they can borrow at 3.8% or L + 0.8%
how to know if choose L + 0.8% is more advantage?1 Correct 🙂
2 You can’t decide on one alone. You need to add together one party borrowing fixed and the other floating; and add together if they both borrowed the opposite to that. If the total is lower then there is a saving to be made that they can then share.
Hey John I’m badly stuck. I don’t understand how you came up with cmc paying yield to counter party? Please explain that bit to me to resolve this please.
You should watch my lecture where I work through this question in full.
You can find it linked from this page:
https://opentuition.com/acca/afm/afm-revision-lectures/
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