Fixed Interest Player v/s Floating Interest Player: Tug of War

Naseem Ahamed

doi:10.4236/tel.2015.54055

Abstract

Swaps have been one of the most widely used derivatives since 1970s and for good reasons. Interest rate swap is a mutual agreement between two parties to pay each other the differential amount of up and above the fixed v/s LIBOR. This paper tries to answer the long standing question of what should have been the range around which the fixed rate should have hovered with respect to fluctuating LIBOR over the years to attain break-even and not to be worse off. This paper analyses for the difference in the average LIBOR of various periods (1 month, 3 months, 6 months and 12 months) with respect to different maturity dates (5 years, 10 years, 15 years, 20 years and 23 years). It looks for the presence of structural change in the trend of LIBOR beginning from 1990 to 2013. This paper will draw the attraction of academic as well as market participants. Fixed rate player refers to the party which agrees to pay the existing floating rate (LIBOR) in the market in exchange of an agreed upon fixed rate from the counter party and vice-versa.

Highlights

Two companies known as party and counterparty enter into an agreement mutually accepted and legally binding upon each other where the fixed rate player agrees to pay a fixed rate of a pre-decided notional amount to the floating rate player in exchange for the floating rate (LIBOR)
The fixed rate player expects much volatility in the interest rates and locks his payment by adhering to a fixed payment whereas the floating rate player anticipates the economy to remain relatively unchanged and pegs his payment schedule according to floating rate
After analyzing substantial existing literature over the topic, it was found that there have been papers on various aspects of swaps as such, but the very idea of what should have been the disposition of the fixed rate player, in the wake of ever changing LIBOR for them to be benefitting out of the arrangement is missing in the existing literature

Summary

Introduction

Two companies known as party and counterparty enter into an agreement mutually accepted and legally binding upon each other where the fixed rate player agrees to pay a fixed rate of a pre-decided notional amount to the floating rate player in exchange for the floating rate (LIBOR). Both the parties have their views about the state of the economy in future and its impact on the interest rates. Corresponding to the above mentioned objectives and voids in the existing literature; the following hypotheses are postulated:

Literature Review

Hypothesis

Data and Methodology

Results

Conclusion