Interest rate swaps - part 2

In this lesson

1. 0:00 Interest rate swap calculation overview
2. 0:26 Step-by-step swap methodology explained
3. 2:31 Tim and Susie scenario setup
4. 3:38 Calculating comparative advantage gain
5. 5:01 Splitting gains and accounting for fees
6. 6:05 Choosing loan types to exploit advantage
7. 7:19 Working out net position for each party
8. 8:12 Arranging swap cash flows between parties
9. 11:59 Alternative bank presentation format
10. 13:09 Summary and key takeaways

About this lesson

We break down the five-step process: calculating comparative advantage, splitting the swap gain between borrowers, arranging the two loans, determining each party's net position, and setting up the cash flow transfers. While the steps are straightforward in theory, the numerical work is detailed and requires careful tracking. Using a worked example with two borrowers (Tim and Susie), we show you exactly how to identify where the market anomaly lies, how fees reduce the available gain, and crucially, how to construct the swap cash flows so both parties end up paying less than they could alone. You'll see how to balance each borrower's position by transferring LIBOR and fixed rate payments between them, and how to verify your answer by checking that both parties reach their target net rates. The calculations are admittedly fiddly—this is a pro forma technique that demands practice—but once you've worked through a few examples, the pattern becomes familiar. We also cover the alternative presentation format you'll sometimes see: a bank-quoted one-sided swap with a bid-offer spread. The method works identically, though the bank always takes the better rate. By the end, you'll understand not just the mechanics but the economic logic: why swaps work, when to use them, and how to calculate the precise cash flows that make them function. This is essential exam technique for advanced financial management.

Duration: 14m