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Interest rate risk management (2) – ACCA (AFM) lectures

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  3. Hi John,

    your example of swap saves both sides a bit of interest costs but clearly isn’t the most effective solution. Company X could borrow fixed at 10% (for themselves) and variable at LIBOR+3% (for company Y) and ask Y to pay back some commission. Y would be willing to pay anything up to 3.5% as this is their saving. Let’s say they split 50:50 so Y pays back 1.75% and we end up with X fixed at 8.25% and Y variable at 4.75%. This is a bit of a swap as Y pays X rate + commission. Would such solution earn any marks or not at all as question is about full swap excercise?

    Also, are swaps just an agreement to pay other party’s rates? Otherwise size of a lone would paly role? If not than my solution above would qualify as swap and give better result. Could you please advise?

    kind regards
    Konrad

    • I am afraid your suggestion would not be regarded as being a swap for the exam and would not earn marks. Company X would be borrowing twice as much as it needed and then acting as a lender to company Y, whereas the purpose of a swap is to end up borrowing what they need and to end up paying fixed or floating as they require, but to save on the interest.

  6. Finally i understand how this interest swap is done! your method is so easy to understand.

    As you mentioned in the lecture on the second method which is more messier, can i just used your first method which is more simpler in the exam?
    just to clarify it because i see the second ‘messy’ method is use commonly in the past paper answer.

  11. Hi John,

    In example 1, what’s the incentive for X to do the swap at all? Surely they’re just exposing themselves to more risk?

    If they were determined to borrow the money on behalf of Y, why wouldn’t they take out both loans and then split that difference so they could save an extra 1% each?

    • The question specifically says that they wish to borrow floating – it is not for you in the exam to decide what they should do!!

      As I explain in the lecture, they no doubt want to borrow at floating rate because their income fluctuates with interest rates. In that case it would be very sensible in terms of reducing risk.

      As for your suggestion – how on earth do you think that they could take out loans for company Y?

  12. John,
    Just done example 2 from the notes (Pg 108). How do we know that currently A is borrowing at fixed rate and B at floating? I had them the wrong way around, e.g. A @ floating and B@Fixed.

    Thank you, Darshana

    • The question says that company A’s income fluctuates with interest rates – that implies that they want to borrow floating.

      A is not currently borrowing anything. They have the choice of borrowing floating directly, or borrowing fixed and swapping. (I assume you are watching the lectures and not using the lecture notes on their own?)

  14. Dear John

    In illustrating the interest rate swap, some answers in BPP鈥檚 revision kit suggested paying the bank either the LIBOR and/or the balancing interest rate. Should I follow their approach although your method is much easier to understand. However I guess in real life it would be the bank who is the matchmaker to arrange the swap for companies so it makes sense to pay the balancing rates to them?

  15. John, in the exam, can it be such that there is no saving on swapping. If yes, then how do we conclude? Do we simply show that there are no potential savings and hence suggest not to swap.

    Thanking you in advance for your help. 馃檪

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