4. Swaps

Swaps are financial contracts between parties to exchange cash flows at specified times and are based on an underlying assets value.

True or False: Because swaps are private agreements between parties, they can be highly customized.

True

False

Consider the case of Company A and Company B:

Company A	Company B
Company A is a financing company.	Company B is a bank.
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 B gives its depositors an average of 6% fixed return on the 10 million certificates of deposit in the bank.
Company A financed company C and earns a fixed interest of 8% per annum.	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 increases by 0.5%.

Which of the two companies will benefit from the protection that the swap provides?

Company A

Company B

This is because earns fixed interest but has to pay interest on its debt on a floating rate that is indexed to the LIBOR. So if LIBOR increases, the company will have to pay more interest on its debt but will still earn the same fixed rate. Because the companies got into an interest rate swap in which would pay the other company a floating-rate interest, an increase in LIBOR would mean more interest earnings from the swap that balances the interest payments on the debt.

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