Monday, July 27, 2009

Eurodollar interest rate swaps

A Eurodollar interest rate swaps is similar to FRA but involves several future periods. in this case parties agree to exchange interest rate of two different kinds for several periods in the future, each usually three or six months long. Again, one of the rates is generally the appropriate LIBOR rate, and the contract often involves the exchange of a fixed rate for a floating rate, as is the case in the one-period FRA. However, an interest rate swap can also involve an exchange of two floating interest rates where one is LIBOR and the second is another interest rate or an index of a package of rates, such as index of Eurocommercial paper rates.
the case in which both sides are contracting a floating rate is referred to as a basis swap or a floating-floating swap. An interest rate swap works as follows;Suppose Ms. smith has a three-year Eurodollar-based loan at 8 percent and wishes that it were a variable-rate debt (perhaps because she expects interest rates to fall in the future)and Mr.Brown has a eurodollar loan on which he is paying six-month LIBOR plus 30 basis points (0.3 percent)and wishes to have a fixed-rate debt. Under the agreed-upon swap arrangement, Smith agrees to pay Brown the six-month LIBOR plus 0.3 percent every six months and brown in turn agrees to pay Smith the 8 percent (perhaps plus some additional amount, for example, 50 basis points per annum). smith has thus converted her fixed-rate commitment to a variable rate and Brown has converted his variable rate to a fixed rate. If interest rates decline, Smith will benefit by obtaining a cheaper loan. Brown feels relieved to have obtained a fixed rate more cheaply than obtaining a formal, new fixed-rate loan refinancing, and he effectively has reduced his interest rate exposure. should interest rate fall during the swap contract and threaten to rise again, smith could phone a swaps trader and enter into a second swap arrangement to again fix the interest rate commitment but this time at the new, lower level.

1 comment:

David Darten said...

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