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Interest Rate Swaps - How they work, & How They've Led to Disaster

An interest rate swap involves borrowing money. Let's say there are two companies, Company A and Company B. Company A has a loan with a fixed interest rate, and Company B has a loan with a variable interest rate that changes over time.

So, they decide to make a swap. Company A agrees to pay the fixed interest rate on Company B's loan, while Company B agrees to pay the variable interest rate on Company A's loan. By doing this, both companies can benefit from the advantages of different types of loans without actually switching loans.

Fixed Rate - Stays the Same

Variable Rate - Fluctuates with Market Sentiment

In essence two parties exchange interest payment obligations on a set principal amount over a specific period. It allows them to effectively convert the nature of their debt from one type to another.

Numeric Example: let's consider a company named Corporation C and a bank named Bank A. C-Corporation has borrowed money from Bank A at a fixed interest rate of 5% per year, while Bank A has borrowed money from Corporation C at a variable interest rate linked to a benchmark, such as the LIBOR (London Interbank Offered Rate) plus 2%.

To reduce risk or take advantage of favorable market conditions, Corporation C and Bank A enter into an interest rate swap. In this swap, Corporation C agrees to pay Bank A the fixed interest rate of 5% on the principal amount it borrowed, while ABC Bank agrees to pay Corporation C the variable interest rate based on the benchmark rate, which may change periodically.

By engaging in this swap, Corporation C effectively converts its fixed interest rate loan into a variable interest rate loan, while Bank A converts its variable interest rate loan into a fixed interest rate loan. Both parties benefit from this arrangement as it aligns with their risk preferences or financial strategies.

Now, let's look at a famous trade that ended well.The interest rate swap entered into by the Harvard University endowment fund. In 2004, Harvard University issued a $2.5 billion bond offering with a fixed interest rate. However, the university wanted to minimize its exposure to rising interest rates.

To achieve this, Harvard entered into an interest rate swap agreement with several banks. Through this swap, Harvard agreed to pay a fixed interest rate to the banks, while the banks paid Harvard a variable interest rate based on the LIBOR. This effectively transformed Harvard's fixed-rate debt into a variable-rate debt.

As interest rates fell over the following years, Harvard benefited from the swap arrangement by paying lower interest payments than it would have under the fixed-rate bond. The successful implementation of this interest rate swap contributed to Harvard's financial stability and reduced its interest rate risk exposure.

On the other hand, the city of Detroit also faced disastrous outcomes from interest rate swaps. Detroit entered into swaps to manage its pension debt obligations. However, as interest rates plummeted, the city faced mounting losses due to unfavorable terms in the swap agreements. This added to the financial difficulties the city was already experiencing, ultimately contributing to its declaration of bankruptcy in 2013.

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