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Hi John,
With reference to the recent ACCA article on interest rate swaps, how do i go about finding amount you receive / pay with regards to the swap,
The ACCA article has given me the working 11% – 1% = 10%, but can you explain this to me? I do not understand the working.
Thank you
I will explain in a different way which I think is more clear.
From the first part of the workings we know that the end result is that both parties will save 1% from the swap, or 0.5% each after the banks fees.
If we use Titans as an example, if they had borrowed floating themselves they would have paid L + 1% and so to save 0.5% then must end up paying a net L + 0.5% (because of the saving).
They in fact borrow fixed and so will be paying interest of 8%. Because they swap, they will also have to pay Kendri’s interest of L + 2%, and will receive 8% from Kendri.
So, so far Titan is paying the following: 8% + (L + 2%) – 8% + 0.5% (banks fees) = L + 2.5%
However we want them to end up paying L + 0.5%.
To make this happen, Kendri will have to pay Titan another 2% (so Titan receives in total from Kendri 8% + 2% = 10%
(As a check, let us to the same for Kendri:
If they borrow fixed themselves then they would pay 11%. But we want them to say 0.5% after fees, so they must end up paying 10.5%.
They instead borrow floating and pay L + 2%, but then swap so that they receive L + 2% from Titan, and pay Titans interest of 8%
So far they are paying a total of (L + 2%) – (L + 2%) + 8% + 0.5% (bank fees) = 8.5%
But…we said that the must end up paying 10.5%, so they will pay an extra 2% (10.5 – 8.5) to Titan. So the total they will pay to Titan is 8% + 2% = 10%.
Thank you John. Your explanation has made it much clearer for my understanding!
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