Page 258 - A Canuck's Guide to Financial Literacy 2020

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• Arbitrage

Parties entering into a swaps contract might be doing so in order to take advantage
of price differentials. See next page for an example of an arbitrage swap agreement.

Common Types of Swap Agreements

Below we've listed the most popular types of swaps that companies may engage in
throughout the financial world.

Interest Rate Swap

An interest rate swap is when two parties agree to exchange streams of interest payments,
over a certain period of time. The most common type of interest rate swaps are fixed-for-
floating interest rate swaps. These are known as vanilla swaps and are the most liquid
interest rate swaps.

Example of an Interest Rate Swap:
Bank A, a fixed rate payer, buys an 8% swap with a $100,000 notional. The counter party is
the Swap Dealer who deals with a floating rate, 6-month LIBOR which is currently 7%. The
payment frequency will be semi-annually.

Every six months, Bank A who is the fixed rate payer pays 4M USD to the Swap Dealer.
(100M * 0.08/2) In return, the Swap Dealer would pay 3.5M. (100 * 0.07/2) The difference is
0.5M which Bank A pays to the Swap Dealer. If the LIBOR rate goes up, so will the payment
to the bank.