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Economics and finance
PUBLIUS
with payments made six months later. The semiannual interest rates are determined by dividing the annual rates (LIBOR and 3.5%) by two. Exhibit A shows the interest payments on each settlement/payment date based on assumed LIBORs on the effective dates. In examining the table, several points should be noted.
ng-rate (fixed-rate) to minimize the borrower’s debt position’s exposure to interest rate changes. For example, a company with floating-rate debt that was expecting a higher interest rate could fix the rate on its debt by combining the company’s floating debt with a fixed-rate payer’s position on a swap, thereby creating a synthetic fixed-rate debt position.
First, the payments are determined by the LIBOR prevailing six months prior to the payment date; thus, payers on swaps would know their obligations in advance of the payment date. Second, when the LIBOR is below the fixed 3.5% rate, the fixed-rate payer pays the interest differential to the floating-rate payer; when it is above 3.5%, the fixed-rate payer receives the interest differential from the floating-rate payer. The net interest received by the fixed-rate payer is shown in Column 5 of the table, and the net interest received by the floating-rate payer is shown in Column 6. Synthetic Positions One of the important uses of interest rate swaps is in creating synthetic fixed-rate or floating-rate liabilities or changing a conventional fixed-rate loan (or floating-rate loan) to a floati-
For example, suppose a corporation has a three-year $10 million floating-rate loan, with the rate set equal to the LIBOR on March 15th and September 15th each year for three years. Fearing that interest rates could increase in the future, suppose the company would like to convert its floating-rate debt to a three-year, $10 million fixed-rate loan starting on 3/15/Y1. Instead of borrowing $10 million from a bank at a fixed rate to refinance its floating-rate debt, the company alternatively could attain a fixed-rate oan by combining its floating-rate loan with a fixed-rate payer's position on the swap.:
An example of a synthetic floating-rate loan is shown in Exhibit A (columns 10-12). The synthetic loan is formed with a 3.5% fixed-rate loan (semiannual payments) and the floating-rate payer's position on the 3.5% for LIBOR swap. Exhibit A: Interest Rate Swap 3.5%/LIBOR Swap with NP = $10 million: Columns 3-6 Synthetic Fixed Rate Loan: Floating-Rate Loan set at LIBOR and Fixed-Payer Position on 3.5%/LIBOR Swap: Columns 7-9 Synthetic Floating-Rate Loan: 3.50% Fixed-Rate Loan and Floating-Payer Position on 3.5%/LIBOR Swap: Columns 10-12
