Question on swaps--page 67 of 2007 Fixed Income book

Hi, can someone explain the following statement: “The swap curve is also telling us how much we can lock in 3-month LIBOR for a specified future period. By locking in 3-month LIBOR it is meant that a party that pays the floating rate is locking in a borrowing rate; the party receiving the floating rate is locking an amount to be received”. My question is really regarding the second part of that statement–how is the party receiving the floating rate locking an amount to be received when the amount in question is yet uncertain? Thanks.

It’s kind of a confusing paragraph but remember what is going on here. A party that is paying floating will SWAP the floating payments for fixed. By swapping his floating payments for fixed payments, he is locking in his payments (borrowings). The opposite happens for the person receiving floating. That person will SWAP these floating rate receipts for fixed receipts. By doing so they have locked in what they will receive. Hope that helps.

I’m pretty sure I got it, but let me just make sure. Let’s say we have three parties–A, B and C. A pays floating to B and in order to ‘hedge’ it will engage in a swap with C where it receives floating and pays fixed. Hence, “party that pays the floating rate is locking in a borrowing rate”. B on the other hand (which is receiving floating from A) will engage in a swap with C where it pays C floating, but receives fixed from C. Hence, “the party receiving the floating rate is locking an amount to be received”. Quite elegant, but one has to go thru all the steps I suppose. The wording reminds me of Level 1 questions. Thanks a lot!

Seems like you have it nailed. The only thing I am not sure of is whether the text is implying both A and B are doing their swaps with C. They could be doing their swaps with two different counterparties. No matter, you seemed to have the concept down. Good luck!

Hmmm… I really don’t know how to read that sentence above and it looks wrong to me. Suppose that I am the fixed-rate payer in a swap. That means that I can “lock-in” a fixed rate on debt assuming I can borrow at floating rates. My fixed rate is just the swap rate + premium over LIBOR at which I can borrow money. That means the fixed rate payer is the person who is locking in a borrowing rate (as opposed to “a party that pays the floating rate is locking in a borrowing rate”). But the question is talking about locking in forward LIBOR rates (i.e., “we can lock in 3-month LIBOR for a specified future period”). The swap curve can be used to bootstrap forward LIBOR rates in the same kind of way that we use treasury curves to bootstrap forward risk free rates. So if I want to “lock-in” some LIBOR rate in some future period, I will be a fixed rate payer in a swap covering that period. However, I do not want to lock-in rates in the period before that, so I need to enter into the reverse swap on the earlier period. That means I enter into two swaps “Pay floating until time T” and “Pay fixed until time T + 3”. The rate that I pay from time T to T+3 is the market’s current expectation for LIBOR during that period. But to lock-in a borrowing rate in the future, I am party to two swaps in which I am the Pay Fixed in one and the Pay Floating in the other. Alternately, you could just enter into an FRA which seems like less work.

I haven’t started looking at level 2 stuff yet. This question is reminding me why.

MWVT9, concur 100% with that assessment. I’m still in awe/shock/disbelief of those who are already studying, but more power to them.

I failed L2 this year, pretty much b/c of FI and Derivatives (though i’m still waiting for the retabulation outcome). This is why I started so early this year, and why I’m not leaving any stone unturned.

This stuff is easy. You can all get it.

Lumiere If you really want to understand this stuff try: The current swap rate for 27 months is 5.5%. For 30 months it is 5.6%. a) If you can always borrow money at LIBOR + 100 bp, at what fixed rate can you lock in a borrowing rate for the period between 27 and 30 months? b) Diagram the cash flows between you and all counterparties. c) (Maybe LIII) What is your default risk in this transaction?

JoeyDVivre I salute your commitment and drive to help others understand the concepts