Re:A visualisation of all of the money in the world
by JackFr on Friday December 18, 2015 @12:39PM
(#10759670)
Consider that borrowing 10 year money at the 6-month LIBOR rate is equivalent to borrowing at LIBOR for 6 months and rolling the debt 19 times.
The swap market provides a linkage between the money market ( borrowing < 1 year) and the capital market (borrowing > 1 year), and allows one to borrow (or lend) where the comparative advantage is better.
The 10 year swap rate is then a market number which represents the relative demand (and supply) within the money & capital markets.
Re:A visualisation of all of the money in the world
by jackcosgrove on Friday December 18, 2015 @10:45AM
(#10759004)
I see. So if you pay cash now you are vulnerable to interest rate swings. Whereas if you use leverage to spread the term of your investment out, you can average the interest rate across the business cycle and achieve more predictable behavior. Is that correct?
Re:A visualisation of all of the money in the world
by lordnacho on Friday December 18, 2015 @11:05AM
(#10759116)
I think point of the example was not to say that you could use leverage. You're borrowing the same amount that you're lending.
The idea of the interest rate swap is simply that some entities prefer to lock in a rate, others prefer to have it float. So they swap those risks.
E.g a simple interest rate swap: I agree to pay you 2% per annum on a reference notional of 100m for 10 years, and in exchange you pay me libor referencing the same notional. At the end of first year let's say libor fixes at 1.98%. Hence I pay you a net 0.02% (2% - 1.98%) of 100m, i.e 20,000. We do this every year for 10 years.
It is just a way to hedge interest rate exposure - e.g I have borrowed 100m paying a Libor-linked interest rate and don't want to run the risk that Libor spikes to 10% or whatever.
There's nothing complicated about this, at least in principle. Derivatives just allow people to hedge out exposures they don't want.