Remember folks, gambling is largely illegal. But corporate swap contracts -- fully okay. Because swaps benefit the economy. Somehow. They just do, okay? Plain Vanilla Interest Rate Swap. The most common and simplest swap is a plain vanilla interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, lets assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a notional amount. investopedia/articles/optioninvestor/07/swaps.asp
Posted on: Thu, 17 Jul 2014 15:56:57 +0000
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