What is Interest Rate Swap?
Simply, an Interest rate swap means exchanging one stream of future interest payments for another. An interest rate swap is a type of derivative contract in which two parties agree to exchange one stream of future interest payments for another based on a specified principal amount. In most cases, interest rate swaps include fixed and floating rate swaps. Like other types of swaps, interest rate swaps are not traded on public markets- only over-the-counter (OTC).
What is the Difference Between Fixed interest rate and Variable rate Interest rate?
Interest rate swaps typically involve exchanging a stream of future payments based on a fixed interest rate for future payments based on a variable interest rate. Therefore, understanding the concepts of fixed-rate loans and floating-rate loans is important to understanding interest rate swaps. A fixed rate is an interest rate on a debt or other security that does not change during the term of the contract or until the bond matures. In contrast, variable interest rates fluctuate over time, and interest rates are usually based on underlying benchmarks.
Floating rate receivables are often used for interest rate swaps, and bond rates are based on the proposed interest rate based on a London bank's London interbank offered rate (LIBOR ). Simply put, LIBOR's interest rate is the average interest rate that major banks participating in the London interbank market charge each other for short-term loans. LIBOR interest rates are a commonly used benchmark for determining other interest rates that lenders impose on different types of financing.
How Do Interest Rate Swaps Work?
Interest rate swaps occur, as a rule, when a party paying a fixed rate and a party paying a floating rate mutually agree that they prefer the other's lender to their own. Those who pay at variable interest rates will find that they prefer a guaranteed fixed rate, but those who receive fixed-rate payments believe that interest rates may rise and will get higher interest payments. Take advantage of this situation. If you prefer to receive floating interest rates, then if interest rates are generally on the rise, then interest rates will rise.
With interest rate swaps, only interest payments are actually exchanged. As mentioned earlier, interest rate swaps are derivative contracts. Both party do not own the debt of the other party. Instead, they simply enter into a contract and pay each other the difference in payments for the loan specified in the contract. They do not swap receivables and do not pay full interest on each interest payment date, only the difference resulting from the swap agreement.
A good interest rate swap contract clearly states the terms of the contract, including the applicable interest rates and payment schedules (e.g., monthly, quarterly, or annually) that each party owes the other party. In addition, the contract will contain both the start date and the end date of the swap contract and both parties agree to be bound by the terms of the contract until the end date. While both parties to an interest rate swap get what they want (one party receives the risk protection of a fixed rate and the other is exposed to the potential benefits of a floating rate), one party ultimately receives a financial reward while the other party receives a financial loss.
If the interest rate increases during the life of the swap contract, the party receiving the floating rate wins, and the party receiving the fixed rate loses. Conversely, if interest rates decline, then the party getting paid the guaranteed fixed rate return will benefit, while the party receiving payments based on a floating rate will see the amount of the interest payments it receives go down.
Example – An Interest Rate Swap Contract in Action
Let’s see exactly what an interest rate swap agreement might look like and how it plays out in action. In this example, companies A and B make an interest rate swap agreement with a nominal value of $100,000. Company A believes that interest rates are likely to rise over the next couple of years and aims to obtain exposure to potentially profit from a floating interest rate return that would increase if interest rates do, indeed, rise. Company B is currently receiving a floating interest rate return, but is more pessimistic about the outlook for interest rates, believing it most likely that they will fall over the next two years, which would reduce their interest rate return.
Company B is motivated by the desire to provide risk protection against potential rate cuts in the form of obtaining the rate of return on bonds committed during that period. The two companies have entered into a two-year interest rate swap agreement with a specified par value of $ 100,000. Company A offers Company B a fixed interest rate of 5% in exchange for LIBOR plus a floating interest rate of 1%. The current LIBOR rate at the start of the interest rate swap contract is 4%. Therefore, in the first place, the two companies are on an equal footing and both receive 5%. Company A's fixed interest rate is 5%, and Company B's LIBOR interest rate is 4% + 1% = 5%.
Now suppose that at the end of the first year of the interest rate swap contract, the LIBOR rate increases to 5.25%, and the interest rate increases. Also, the swap agreement stipulates that interest payments will be made annually (so when each company receives an interest payment) and that Company B's variable interest rate is the prevailing LIBOR rate at that time. Suppose using. The interest payment is required. Company A owes Company B $5,000 (5% of $100,000) at a fixed rate. However, as interest rates have risen, as evidenced by the LIBOR benchmark rate rising to 5.25%, Company B owes Company A $6,250 (5.25% plus 1% = $100,000, 6.25%). To avoid the trouble and expense of both parties in paying each other in full, the terms and conditions of the swap state that only the net difference in payments is paid to the respective party. In this case, Company A would receive $1,250 from Company B.
Company A benefits from assuming the additional risk involved in accepting floating rate returns. Company B lost $1,250, but still got what it wanted. That is, it is a hedge against a possible fall in interest rates. Let's see what would have happened if the interest rate market had gone in the opposite direction. What if the LIBOR ratio drops to 3.75% at the end of the first year of the contract? With its constant returns, Company B will still have $5,000 from Company A. However, Company B should owe only $4,750 to Company A (3.75% plus 1% = 4.75%; 4.75% of $100,000 = $4,750). This is resolved by having Company A pay Company B $250 ($5,000 minus $4,750 = $250). In this scenario, Company A suffered a small loss, and Company B gained an advantage.
What are Interest rate swap risks?
Interest rate swaps are an effective type of derivative that can be beneficial to both parties using them in different ways. However, swap agreements also carry risks. A significant risk is the counterparty risk. As the parties involved are often large corporations or financial institutions, the counterparty risk is generally relatively low. However, if either party is in default and unable to meet its obligations under the Interest Rate Swap Agreement, it would be difficult for the other party to collect them. It would have an executive contract, but following the legal process could be a long and winding road. Addressing the unpredictable nature of floating rates alone adds inherent risk to both sides of the transaction.
Option Trading:
Options: Calls and Puts
A derivatives contract grants the holder the right (but not the obligation) to buy or sell the asset at the expiration of the strike price.
What are the options: Calling and Putting? An option is a derivative that gives the buyer the right (but not the obligation) to buy or sell the underlying asset on a specific date (expiration) at a specific price. There are two types of options: call and put. American options can be exercised at any time prior to their expiration date. The option is continental To conclude a call option contract, the buyer must pay the option insurance premium, Two common options are Calls and Puts.
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Call options
This call gives the buyer the right to buy the underlying assets at the event price specified in the option contract but is not obligatory. Investors buy calls with the belief that the price of their underlying assets will rise and sell calls if the price falls
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Put options
Put options give the buyer the right, but not the obligation, to sell the underlying asset at the exercise price specified in the contract. If the buyer of put options exercises him, the writer (seller) of put options is obliged to buy the asset. An investor buys it when they feel that the price would fall and sells it when the price increases.
Payoffs for Options calls and puts;
Calls:
Buyers of call options pay a premium for all options at the time of signing the contract. Therefore, if the market moves in his favor, the buyer will benefit from the potential profits. Options cannot result in additional losses in excess of the purchase price. This is one of the most attractive features of calling options. For limited investments, the buyer guarantees unlimited profit potential with known completely limited potential losses. If the asset's spot price does not rise above the option strike price before the option expires, the investor loses the amount paid for the option. However, when the price of the underlying asset exceeds the strike price, the expensive buyer benefits. The profit amount is the difference between the market price and the option strike price multiplied by the incremental value of the underlying asset minus the price paid for the option.
For example, a stock option is 100 shares of the underlying stock. Assume a trader buys one call option contract on ABC stock with a strike price of $25. Pay $150 for this option. On the option's expiration date, ABC shares will sell for $35. The buyer/option holder exercises the right to buy 100 shares of ABC at a price of $25 per share (the option strike price). He immediately sells the stock at the current market price of $35 per share.
He paid $2,500 for 100 shares (25 x $100) and sells the stock for $3,500 (35 x $100). His profit from the option is $ 1,000 ($ 3,500- $ 2,500) minus the $ 150 premium paid for the option. Therefore, his net profit is $ 850 ($ 1,000 to $ 150), excluding transaction costs. This is a large return on investment (ROI) with an investment of only $ 150.
Sale of call options:
The drawbacks of call option sellers are potentially unlimited. Since the spot price of the underlying asset exceeds the strike price, the option creator suffers a corresponding loss (equal to the option's buyer's profit). However, if the market price of the underlying asset does not rise above the strike price of the option, the option will expire worthlessly. The seller of the option receives the premium amount for which he was given the option.
Below is an example showing the potential payout of a call option on RBC stock, with an option premium of $10 and a strike price of $100. In this example, if the price of RBC stock does not exceed $100, the buyer loses $10. Conversely, the call writer is in the capital as long as the stock stays below $110.
Puts:
A put option gives the buyer the right to sell the underlying asset at the strike price of the option. The buyer's profit from this option depends on how far the cash price has fallen below the strike price. If the spot price is lower than the strike price, the buyer is in the money. If the cash price remains above the strike price, the option is not exercised and expires. The option buyer's loss is again limited to the premium paid for the option.
If the cash price of the underlying commodity is lower than the transaction price of the contract, the issuer of the put option is "out-of-the-money". These losses equal the gains made by the put option buyer. If the spot price stays above the contract's strike price, the option expires unexercised and the writer pockets the option premium.
Application of options: calls and puts options
Options: Call and put options are mainly used by investors to protect themselves from the risks of existing investments. For example, it is often the case that an investor who owns shares buys or sells stock options to hedge his direct investment in the underlying asset.
Investments in options are designed to at least partially offset the losses that may be incurred by the underlying asset. However, options can also be used as standalone speculative investments.
Hedging - Buy put:
If an investor thinks that some of the stocks in his portfolio may decline but does not want to give up his long-term position, he can buy put options on the stock. If the stock price falls, the gains from the put options will offset the losses from the real stock.
Investors often adopt such a strategy during times of uncertainty, such as earnings season. They can buy put options on specific stocks in their portfolio or buy index put options to protect a well-diversified portfolio. Put options are often used by mutual fund managers to reduce a fund's exposure to downside risk.
Speculation - buying puts options or selling calls:
If the investor believes that the price of a security is likely to rise, he can buy call options or sell call options to take advantage of this price increase. When buying a call option, the investor's overall risk is limited to the premium paid for the option. Their potential profit is, in theory, unlimited. This is determined by the investor according to the extent to which the market price is higher than the practical price of the option and the number of available options.
The situation is reversed for the seller of a put option. Their potential profit is limited to the premium received for selling the put option. These potential losses are unlimited. The market price is equal to the amount below the option's strike price multiplied by the number of options sold.
Buying or selling of shortened securities:
Investors can either sell the currency or buy a put to take advantage of the lower price. The currency writer feature is limited to the option premium. Buyers will likely encounter unlimited plus surface, but, like option prices, they have a limited minus side. If the market price of the underlying security falls, the buyer of the put makes a profit as long as the market price drops below the option's strike price. If the investor's intuition is wrong and the price does not go down, the investor only loses the option premium.