# SWAP agreement exemple

## SWAP agreement exemple

Company A, pays to a lender a variable interest rate (nominal \$1M) every period (LIBOR+2%).  Ex: in period 1, if LIBORis 5%, Company A pays 7% or \$70k to the lender in that period. In period 2, if Libor goes down to 4%, Company A pays 6% or \$60k in interest.

LIBOR: One of the major benchmark for variable  interest rates.

Company B borrows \$1M but it borrows at a fixed rate of 8%. So each period, regadless of the period, Company B pays 8% of \$1M, \$80 each period.

Company A, doesn’t like the variability and unpredictability of LIBOR;  A will feeling insecure for the next period payement, and company B will feel like over paying for the interest rate.  B can also think that in short term, interest rates are going to be down. So that’s a bigger reason why they want to become a variable rate barrower.

These two companies can enter in an agreement that is called interest rate swap where the company A agrees to pay to B, 7% on a notional \$1M loan. So notional is not going to change hand. In return, company B agrees to pay a variable rate (LIBOR+1%) every period.

So let’s think about what happens to the company A on period 1. It had to pay \$70k to lender 1 and it also has to pay \$70k to B but in exchange it gets \$60k from B. So the net is \$80k. In period 2, A pays to lender 1  60k (LIBOR(4%)+2)  and \$70k to B and in exchange it would get \$50k from the swap agreement. So the net is \$80k, there is not a change in period 2.

Company B will get \$70k from A and it pays 50k to A. It also pays \$80k for the lender 2. So net is \$60K in period 2. (and 70k net in period 1).

So now, Company A is going to pay \$80k fix every period and company B is going to pay essentially a variable rate.

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