Let's Pretend

In previous posts, I've talked about derivatives in general terms, but today I'd like to focus on the most widely used type of derivative - the swap. I'm going to use the example of a simple interest rate swap in a single currency (although, be warned - there are no simple swaps). For purposes of this discussion, let's pretend it is January of 2008 and you are the CFO of a medium-sized company.

You need to borrow $20 million from the bank. Your banker offers you a very good, fixed interest rate of 3.5% (50 basis points less than the current LIBOR rate of 4%) and you say yes. Your monthly interest payment is $70,000. Because you are a saavy user of the credit markets, you decide to enter into an interest rate swap to hedge your exposure in the event interest rates fall.

An interest rate swap is a fake transaction where two parties pretend to borrow money from each other. The only thing that prevents the transactions from being a wash is that one phony borrowing is at a fixed rate and the other is at a floating rate. The amount of the phony loan is called the "notional amount." Once a month, you and the other party get together and compare interest rate payments. The party with the higher payment turns over the difference.

Your swap is structured like this - you "borrow" $20 million from a third party (let's call them "Wasp") at the LIBOR rate and Wasp "borrows" $20 million from you at 3%. Therefore, Wasp's payment to you will always be $60,000, but your payment to WASP will vary with the LIBOR rate. At your initial settlement, you owe Wasp money. Your imaginary LIBOR-pegged payment would be $80,000. $80,000 minus Wasp's pretend payment of $60,000 = $20,000. You pay Wasp $20,000. In total, you end up handing over (to Wasp and the bank) $90,000. Not such a good deal for you, yet.

Then, the credit markets collapse and interest rates go down with them. Your 3.5% loan becomes a bad bargain, but your interest rate swap begins to bear fruit. At your next settlement, your LIBOR-pegged payment is down to 2% so Wasp owes you $40,000. If you apply this money to your bank loan, your reduce your interest payment to $30,000.

See how simple that is?