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
JoeyD: I think we are all missing the boat here. Locking in a fixed rate on a swap has nothing to do with LIBOR rates at all. I know, I know. How could that possibly be true given the fact that floating debt is almost always tied to LIBOR? No one has talked about the actual swap spread yet, which is really what matters most in this context. An earlier comment stated that the fixed rate is simply a t-bill of whatever maturity + LIBOR, which is fundamentally false. In reality, the fixed rate is made up of the t-bill + the swap spread. The swap spread is derived from bootstrapping forward rates, and has alot to do with where we believe treasury rates will be setting in the future. For instance, because of the misstep between LIBOR and and the FED FUNDS target rate and the flight to quality pushing treasury yields down, you can effectively lock in a fixed rate at 1.00% under LIBOR today. Check the numbers. It’s true. You don’t bootstrap swap rates to derive forward LIBOR rates. Swap rates are simply a prediction of where we believe LIBOR to be in the future. There is no derivation to try to figure out where they will be in the future, it’s already priced into the swap rate (t-bill yield + swap spread). In addition, I think what Joey D was trying to explain was the hedging element involved in a swap. Somone has floating rate debt to finance the purchase of a building. Someone else says they will pay this person’s floating payments in exchange for the receipt of a fixed rate. That second guy is an idiot because he exposes himself to tons of risk if floating rates move higher, right? Wrong!!! That guy hedges himself by shorting treasury or eurodollar futures (essentially where we get fowards…different from bootstrapping). When rates climb and prices fall, that short makes money, and that’s why if a swap is unwound in a higher rate environment, there is a payment to the fixed rate payer. After all, the swap was suppossed to provide him protection from higher rates. Alternatively, in a lower rate environment, if the swap is unwound early, there is a payment from the floating rate payer to the fixed rate payer. What the hedging does is essentially lock in a spread, so wherever rates move, the hedger makes the same amount of money, which is also why profit for a firm can be booked at the inception of the swap. Swaps are not easy, and this is just a plain vanilla example. Just cut it to the basics. Someone has a risk (rates go higher, currencies change) and doesn’t have the capability to hedge themselves. Someone else does, and agrees to pay floating rates becuase they can hedge. The hedge locks in a spread (profit) so wherever rates go, the same spread applies (Hedge makes money if rates go up, and loses money when rates go down, but the spread stays intact because you’re receving the higher fixed rate). It’s difficult to be brief. Hope this helps. CJ