The swap terms available to the insurance company are as follows:
- Every six months the life insurance company will pay LIBOR.
- Every six months the life insurance company will receive 8.40%.
What has this interest-rate contract done for the bank and the life insurance company? Consider first the bank. For every six-month period for the life of the swap agreement, the interest-rate spread will be as follows: Read the rest of this entry »
So far we have merely described an interest-rate swap and looked at its characteristics. Here we illustrate how they can be used in asset/liability management. Other types of interest-rate swaps have been developed that go beyond the generic or “plain vanilla” swap described and we describe these later.
An interest-rate swap can be used to alter the cash flow characteristics of an institution’s assets so as to provide a better match between assets and liabilities. The two institutions we use for illustration are a commercial bank and a life insurance company. Read the rest of this entry »
An interest-rate agreement is an agreement between two parties whereby one party, for an upfront premium, agrees to compensate the other at specific time periods if a designated interest rate, called the reference rate, is different from a predetermined level. When one party agrees to pay the other when the reference rate exceeds a predetermined level, the agreement is referred to as an interest-rate cap or ceiling. The agreement is referred to as an interest-rate floor when one party agrees to pay the other when the reference rate falls below a predetermined level. The predetermined interest-rate level is called the strike rate.
The terms of an interest-rate agreement include
- The reference rate
- The strike rate that sets the ceiling or floor
- The length of the agreement
- The frequency of settlement
- The notional principal amount
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There are two ways that a swap position can be interpreted: (1) as a package of forward/ futures contracts, and (2) as a package of cash flows from buying and selling cash market instruments.
Package of Forward Contracts Consider the hypothetical interest-rate swap described earlier to illustrate a swap. Let’s look at party X’s position. Party X has agreed to pay 10% and receive six-month LIBOR. More specifically, assuming a $50 million notional principal amount, X has agreed to buy a commodity called six-month LIBOR for $2.5 million This is effectively a six-month forward contract in which X agrees to pay $2.5 million in exchange for delivery of six-month LIBOR. If interest rates increase to 11%, the price of that commodity (six-month LIBOR) is higher, resulting in a gain for the fixed-rate payer, who is effectively long a six-month forward contract on six-month LIBOR. The floating-rate payer is effectively short a six- month forward contract on six-month LIBOR. There is therefore an implicit forward contract corresponding to each exchange date. Read the rest of this entry »
In an interest-rate swap, two parties (called counterparties) agree to exchange periodic interest payments. The dollar amount of the interest payments exchanged is based on a predetermined dollar principal, which is called the notional principal amount. The dollar amount that each counterparty pays to the other is the agreed-upon periodic interest rate times the notional principal amount. The only dollars that are exchanged between the parties are the interest payments, not the notional principal amount. In the most common type of swap, one party agrees to pay the other party fixed-interest payments at designated dates for the life of the contract. This party is referred to as the fixed-rate payer. The other party, who agrees to make interest rate payments that float with some reference rate, is referred to as the floating-rate payer. The frequency with which the interest rate that the floating-rate payer must pay is called the reset frequency. Read the rest of this entry »
