problem a.

PIMCO Understanding Investing Interest Rate Swaps Interest rate swaps have become an integral part of the fixed income market. These derivative contracts, which typically exchange - or swap - fixed-rate interest payments for floating-rate interest payments, are an essential tool for investors who use them in an effort to hedge, speculate, and manage risk. WHAT IS AN INTEREST RATE SWAP? fixed rates, and receive floating-rate payments. In this way. An interest rate swap is an agreement between two parties to corporations could lock into paying the prevailing fixed exchange one stream of interest payments for another, over rate and receive payments that matched their floating rate a set period of time. Swaps are derivative contracts and trade debt. (Some corporations did the opposite - paid floating over-the counter. and received fixed - to match their assets or liabilities.) The most commonly traded and most liquid interest rate However, because swaps reflect the market's expectations for swaps are known as "vanilla" swaps, which exchange fixed- interest rates in the future, swaps also became an attractive rate payments for floating-rate payments based on LIBOR tool for other fixed income market participants, including (London Inter-Bank Offered Rate). which is the interest rate speculators, investors and banks. high-credit quality banks charge one another for short-term financing. LIBOR is the benchmark for floating short-term WHAT IS THE SWAP RATE? interest rates and is set daily. Although there are other types The "swap rate" is the fixed interest rate that the receiver of interest rate swaps, such as those that trade one floating demands in exchange for the uncertainty of having to pay rate for another, vanilla swaps comprise the vast majority of the short-term LIBOR (floating) rate over time. At any the market. given time, the market's forecast of what LIBOR will be in Investment and commercial banks with strong credit ratings the future is reflected in the forward LIBOR curve. are swap market makers, offering both fixed and floating- At the time of the swap agreement, the total value of rate cash flows to their clients. The counterparties in a typical the swap's fixed rate flows will be equal to the value of swap transaction are a corporation, a bank or an investor on expected floating rate payments implied by the forward one side (the bank client) and an investment or commercial LIBOR curve. As forward expectations for LIBOR change. bank on the other side. After a bank executes a swap, it so will the fixed rate that investors demand to enter into usually offsets the swap through an inter-dealer broker new swaps. Swaps are typically quoted in this fixed rate, or and retains a fee for setting up the original swap. If a swap alternatively in the "swap spread," which is the difference transaction is large, the inter-dealer broker may arrange between the swap rate and the equivalent local government to sell it to a number of counterparties, and the risk of the bond yield for the same maturity. swap becomes more widely dispersed. This is how banks A similar principle applies when looking at money itself that provide swaps routinely shed the risk, or interest rate and considering interest as the price for money. If the real exposure, associated with them. return (adjusted for inflation) on a financial asset differs Initially, interest rate swaps helped corporations manage between two countries, investors will flock to the country their floating rate debt liabilities by allowing them to pay with the higher returns. Interest rates have to change to Fixed rate RECEIVER PAYER Floating (LIBOR) A company of Allianz On