Interest Rate Swap (IRS) – Mechanics & Valuation

1. Introduction

The "Plain Vanilla" IRS is the building block of the swap market. Let's understand how money actually flows between the parties.

2. Core Concepts: Fixed vs Floating Rate

Before understanding Swaps, you must know the two types of interest rates:

• Fixed Rate: The interest rate remains the same throughout the loan tenure (e.g., 8% p.a.). It provides certainty but no benefit if market rates fall.
• Floating Rate: The interest rate changes periodically based on a benchmark (Reference Rate).
  • Example: LIBOR + 2%. If LIBOR is 4%, you pay 6%. If LIBOR rises to 5%, you pay 7%.
  • Risk: You are exposed to market fluctuations.

3. The Mechanism: Example

Scenario:

• Company A: Has a loan at a Floating Rate (LIBOR + 1%). It fears rates will rise. It wants a Fixed Rate.
• Company B: Has a loan at a Fixed Rate (5%). It expects rates to fall. It wants a Floating Rate.

The Swap Deal:

1. Company A agrees to pay Company B a Fixed Rate (say 6%).
2. Company B agrees to pay Company A a Floating Rate (LIBOR).
3. Net Result: Company A has effectively converted its liability from Floating to Fixed.

4. Netting of Payments

In reality, they don't send two cheques. They calculate the Net Difference.

• If Fixed Rate > Floating Rate: Company A pays the difference to B.
• If Floating Rate > Fixed Rate: Company B pays the difference to A.

5. Diagram: The Swap Structure

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6. Exam Notes: Writing the Answer

Question: "Explain the mechanics of a Plain Vanilla Interest Rate Swap." (10 Marks)

Answering Structure:

1. Define: "Agreement to exchange Fixed for Floating."
2. Parties: "Fixed Rate Payer (Buyer)" and "Floating Rate Payer (Seller)".
3. Netting: "Only the differential amount is exchanged periodically."
4. Benefit: "Hedging against interest rate fluctuations."

7. Quiz Time! 🎯

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