Sunday, February 13, 2011

Derivatives Overview Part 2 - Interest Rate Derivatives

Remember back in 2008 each Sunday night seemed to be a new class on the latest financial product that failed.  Guess what?  They are still out there and the risk in many cases is even greater.  So as we watch a market chop up anyone trying to price in reality, time is better served for longer term and or macro traders to study and be prepared for those falling shoes still being levitated by the Fed, FASB and Treasury.

Over the next few days I'll discuss various derivatives.  Derivatives are important financial products but like anything in moderation.  Derivatives have outgrown their intended use and as a result represent major systemic risk to the global economy that still have yet to be addressed.

Below is an example of an interest rate derivative product.  In its most basic definition, all this product does is convert a floating rate to a fixed rate and vice versa.

GM needs capital and wants to sell debt to GEICO.  They offer to sell $100 million in debt to GEICO for five years at an adjustable rate of 6 month Libor plus 200 bp (2%).  GEICO loves the deal but wants a fixed rate.  The interest rate derivative is the product that allows this deal to get done.


Transaction 1 - The selling of debt between GM and GEICO



GEICO gives GM $100 Million
GM pays GEICO
6 month Libor + 2%












Transaction 2 - GEICO converts their adjustable rate to a fixed rate

GEICO needs to find someone who will convert their adjustable rate for a fixed rate.
They call JPM who agrees to buy GEICO's 6 month Libor and will pay GEICO 4%.


JPM pays GEICO 4%

GEICO gives JPM 6 month Libor


The Result
  • GM sold $100 million in debt to GEICO and pays an adjustable rate
  • GEICO invested $100 million in GM at a fixed rate of 6%
  • JPM purchased 6 month Libor for 4% for a period of five years




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