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Chapter 6

Overview of an interest rate swap

LIBOR LIBOR
Company D BANK Company E

– pays a fixed rate – will make a – pays a floating

to its lenders profit as long as rate to its lenders
– arranges to pay the fixed rate paid – arranges to pay a
LIBOR to the fixed rate to the
bank in exchange by Company E is bank in exchange
for a fixed rate bigger than the for LIBOR

Net effect = floating fixed rate paid to Net effect = fixed rate

rate FIXED Company D FIXED
RATE RATE

FIXED RATE FLOATING RATE

Original Original
lenders to lenders to
Company D Company E

Considering the numerical example above in the context of the diagram:

 Company D wants to swap a fixed rate to a floating rate, so would pay LIBOR to
the bank in exchange for 3.00%

 Company E wants to swap a floating rate to a fixed rate, so would pay 3.10% to
the bank in exchange for LIBOR

 The bank would make a profit by setting up swaps with both Company D and
Company E, because the LIBOR payments net off, and the fixed rate received
by the bank is bigger than the fixed rate paid.

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