Interest Rate Swap (IRS)

[changedman]

Guys....im doing a mini project @ school. Couple of things that confused me about IRS. Hopefully someone here can clear my doubts.

I understand the basic of IRS hedging against the raising borrowing interest rate, but what i do not understand is if i were to receive floating rate and pay fixed rate. How does this IRS hedge against my interest when i am still paying the loan interest?

For example,

i receive Floating rate : 0.2xxxxxx%
i pay Fixed rate : 1.7%

My current loan rate is 1.89% which i am still paying.

So if i were to do IRS, i am paying 1.7%+1.89% less 0.2xxxxx% ?

isn't this way i am paying more interest?



I know this might be a stupid question but i just cant figure it out.

Thanks!

 

[flikmy]

Guys....im doing a mini project @ school. Couple of things that confused me about IRS. Hopefully someone here can clear my doubts.

I understand the basic of IRS hedging against the raising borrowing interest rate, but what i do not understand is if i were to receive floating rate and pay fixed rate. How does this IRS hedge against my interest when i am still paying the loan interest?

For example,

i receive Floating rate : 0.2xxxxxx%
i pay Fixed rate : 1.7%

My current loan rate is 1.89% which i am still paying.

So if i were to do IRS, i am paying 1.7%+1.89% less 0.2xxxxx% ?

isn't this way i am paying more interest?



I know this might be a stupid question but i just cant figure it out.

Thanks!

It depends on what you want to hedge.

Since you said that you want to hedge against rising borrowing interest rate, then I would assume that you are initially paying the loan based on a floating rate. (as it would then rise when interest rates rise).

So, to hedge (make your interest payments fixed), you want to receive a floating rate and pay a fixed rate instead. The floating rate you receive from the IRS will match the floating rate on the existing loan payment and you're left with the fixed payment you need to pay on the IRS.

Hope that helps.

 

[changedman]

It depends on what you want to hedge.

Since you said that you want to hedge against rising borrowing interest rate, then I would assume that you are initially paying the loan based on a floating rate. (as it would then rise when interest rates rise).

So, to hedge (make your interest payments fixed), you want to receive a floating rate and pay a fixed rate instead. The floating rate you receive from the IRS will match the floating rate on the existing loan payment and you're left with the fixed payment you need to pay on the IRS.

Hope that helps.

Hey thanks for the reply!
btw the scenario that was presented in my assignment is that, my loan rate is, 1.5%+SIBOR.

so that means i am paying 1.5%(the original loan rate)+1.7%(IRS fixed rate) = 3.2% less 0.2xxxxx%(floating rate). isnt this more expensive than not doing IRS at all?

i mean what are the chances the rate will increase by 1.1% over a 5 years period? is it common in the past that interest rate will jump by so much in 5 years?

 

[Shiny Things]

Hey thanks for the reply!
btw the scenario that was presented in my assignment is that, my loan rate is, 1.5%+SIBOR.

so that means i am paying 1.5%(the original loan rate)+1.7%(IRS fixed rate) = 3.2% less 0.2xxxxx%(floating rate). isnt this more expensive than not doing IRS at all?

Yep, it is. It's the difference between borrowing for 3 months and rolling that every three months for five years, and borrowing for 5 years fixed.

That's the price you pay for fixing your interest rate in an environment where yields increase over time. You're paying 1% to hedge against the risk that yields go up by 2% or 3% or 5%.

i mean what are the chances the rate will increase by 1.1% over a 5 years period? is it common in the past that interest rate will jump by so much in 5 years?

The chances are pretty darn good. 1.1% is less than five Fed hikes; we could be 1.1% higher by the end of 2016.

 

[icicic]

Sorry guys. Sibor loans are not hedgeable. Only sor

Sent from Sony D6653 using GAGT

 

[chopra]

It's not a stupid qn. IRS n CDS are the products created by genuises who crash e market in 2008

 

[changedman]

Sorry guys. Sibor loans are not hedgeable. Only sor

Sent from Sony D6653 using GAGT

ermm i should present in my assignment as SOR+floating rate? why can only SOR be hedged? i was given LIBOR/SOR/SIBOR/EUBO.

Btw guys, thanks for the replies so far. Appreciate it.

I was given another scenario whereby my total USD borrowings are USD50M
Should i IRS hedge it? if yes why and if no why?

i answered,

"It is not feasible to hedge such a small borrowing as cost of IRS is expensive. And even if the USD interest rate rises, the cost of borrowings at floating rate is still cheaper than the cost of IRS."

Am i correct in answering this way? i actually googled around and came to this conclusion.

 

[flikmy]

ermm i should present in my assignment as SOR+floating rate? why can only SOR be hedged? i was given LIBOR/SOR/SIBOR/EUBO.

Btw guys, thanks for the replies so far. Appreciate it.

I was given another scenario whereby my total USD borrowings are USD50M
Should i IRS hedge it? if yes why and if no why?

i answered,

"It is not feasible to hedge such a small borrowing as cost of IRS is expensive. And even if the USD interest rate rises, the cost of borrowings at floating rate is still cheaper than the cost of IRS."

Am i correct in answering this way? i actually googled around and came to this conclusion.

Based on your answer, I would ask what are the costs which makes this swap expensive? The 1+% spread on the fixed rate compared to current floating rates? That is just how the swap is priced based on what the market expects rates to be in the future which isn't really a cost.

There are other costs involved in doing a swap including signing legal papers, credit risks, operational, etc. However, I think 50 million is still a reasonable size for hedging.

 

[changedman]

Based on your answer, I would ask what are the costs which makes this swap expensive? The 1+% spread on the fixed rate compared to current floating rates? That is just how the swap is priced based on what the market expects rates to be in the future which isn't really a cost.

There are other costs involved in doing a swap including signing legal papers, credit risks, operational, etc. However, I think 50 million is still a reasonable size for hedging.

By IRS cost i mean, if i do without IRS. I am only paying 1.89%(1.5%+SOR) which is my original loan interest.

So if i were to do IRS, i am paying 1.7% so that means i am paying 1.89%+1.7% less the floating rate i am supposed to receive from the IRS.

isnt this 1.89% cheaper than (1.89+1.7-Floating Rate) ? unless of cause if the floating rate increase substantially.

 

[icicic]

ermm i should present in my assignment as SOR+floating rate? why can only SOR be hedged? i was given LIBOR/SOR/SIBOR/EUBO.

Btw guys, thanks for the replies so far. Appreciate it.

I was given another scenario whereby my total USD borrowings are USD50M
Should i IRS hedge it? if yes why and if no why?

i answered,

"It is not feasible to hedge such a small borrowing as cost of IRS is expensive. And even if the USD interest rate rises, the cost of borrowings at floating rate is still cheaper than the cost of IRS."

Am i correct in answering this way? i actually googled around and came to this conclusion.

Sibor is not tradeable
Read a little on forward curve to answer your question on cost vs hedge

Sent from Sony D6653 using GAGT

 

[changedman]

Sibor is not tradeable
Read a little on forward curve to answer your question on cost vs hedge

Sent from Sony D6653 using GAGT

thanks! , trying to create a curve now haha