4. Swaps Swaps are financial contracts between parties to exchange cash flows at specified times and are based on an underlying asset's value. In an interest rate swap, there is a predetermined amount of debt that each party involved in the swap needs to raise. This amount is referred to as Currency principal Notional principal Consider the case of Company A and Company B: Company A - Company A is a financing company. - Company A has 30% debt in its capital structure, out of which 55% is floating-rate debt indexed to the LIBOR (London interbank offered rate). - Company A financed company C and earns a fixed interest of 8% per annum. Company B - Company B is a bank. - Company B gives its depositors an average of 6% fixed return on the 10 million certificates of deposit in the bank. - The bank lends money to corporations at floating rates indexed to the LIBOR. The financing company agrees to pay fixed-rate obligations to the bank, and the bank pays the financing company a floating-rate payment based on LIBOR. Company A and Company B enter into an interest rate swap agreement with each other for three years. Six months into the contract, LIBOR decreases by 0.50%. Which of the two companies will benefit from the protection that the swap provides? Company B Company A This is because earns floating interest that is indexed to the LIBOR but has to pay fixed interest on its debt. So if LIBOR decreases, the company earns less but will have to pay the same interest on its debt. Because the companies got into an interest rate swap in which would pay the other company a fixed interest rate, a decrease in LIBOR would mean more interest earnings from the swap in the form of fixed interest that balances the decreased earnings from the floating interest rate. Another kind of swap is a credit default swap. A credit default swap (CDS) is a contract that transfers credit risk from one counterparty (protection buyer) to another counterparty (protection seller). Which party is required to post collateral to support its payment obligation? Debt holder Insurer