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Dear tutor,
Firstly, thank you for all the wonderful work you do here.
I have a question on calculating interest rate differentials when it comes to interest rate swaps. I have got two examples with conflicting methods in on calculating the benefit of swaps from interest rate differentials.
Example 1 – From P4 technical article currency swaps
The example is about an interest rate swap
Barrow Co Greening Co Interest rate differential
USA 3.6% 4.5% 0.9%
Eurozone EURIBOR + 1.5% EURIBOR + 0.8% 0.7%Benefit 1.6
In example 1, the benefit is worked out by ADDING the interest rate differentials.
Example 2 From BPP revistion kit Q69 CMC co
CMC Co Counterparty Interest rate differential
Fixed rate 2.2% 3.8% 1.6%
Float rate Yield rate + 0.4% Yield rate + 0.8% 0.4%Benefit 1.2
In example 2 the benefit is worked out by DEDUCTING the interest rate differentials against each other.
Question is, how do I know when to add the interest rate differentials to get the benefit? And how will i know when to deduct the interest rate differentials to get the benefit?
These two methods appear to contradict each other. Please help.
Tobi.
If you watch my free lecture on swaps, then you will see that I do not look at the interest rate differentials. The way I do it in the lectures I think is a lot more logical and easier to understand (and would obviously get full marks in the exam).
Also (although you didn’t ask about this), there are various ways in which the two parties can settle up between themselves in order to make sure that they both get the required benefit of the swap. The examiner does it different ways in different answers, but that is not relevant for the marks – again the way I do it in the lectures in fine to get the marks 🙂
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