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Vocabulary Plain Vanilla Swap
Most common type of swap Two parties swap fixed rate for a floating rate or vice
versa Notional Principal
Specified dollar amount on which the exchange interest payments are based
LIBOR - London Interbank Offer Rate Determines floating interest rates
Basis Points - 100 = 1%
Pays Out
Claims - Actuarially computed Law of large numbers
7% on $40 Million = $2.8 Million Fixed rate
Receives
Investments LIBOR + 160 Bp Break even = 5.4% + 160 Bp = 7% $2.8 Million Floating rate subject to change
Floating Rate Increases
LIBOR (6%) + 160 Bp = 7.6% $3.04 Million Good
Decreases LIBOR (5%) + 160Bp = 6.6% $2.64 Million Bad
Pays Out
Savings accounts, CD’s Interest
LIBOR + 40 Bp Break Even = 7.6% + 40 Bp = 8% $3.2 Million Floating rate
Floating Rate Increases
LIBOR (8%) + 40 Bp = 8.4% $3.36 Million Bad
Decreases LIBOR (7%) + 40 Bp = 7.4% $2.96 Million Good
Potential Problem?
Floating rates increase Good for insurance company Bad for bank
Floating rates decrease Good for bank Bad for Insurance company
Intermediary
Accepts 8% fixed from bank Pays 8% fixed to insurance company
Accepts LIBOR + 160 Bp from insurance company
Pays LIBOR +155 Bp to bank
Results
Intermediary keeps 5 basis points ($20,000)
Insurance company keeps 1% ($400,000)
Bank keeps 115 Bp ($460,000)
Intermediaries
Intermediaries key to the swap Match two companies with similar needs Different notional principles - Intermediary
takes a position to fill swap