INTEREST RATE SWAP Harvard Case Solution & Analysis

INTEREST RATE SWAP Case Solution

Describe historical relationship between the change in the levels of rates and changes in the slope of rates.  

Interest rate swaps are derivative instrument which enable both parties involved in swap agreement to exchange fixed and floating cash flows. The swaps are used widely by companies and banks to hedge increase or decrease in interest rates and their adverse affect on the company’s overall interest rate cost. There is a relationship between change in the level of rates and change in the slope of rates. The rate of change in the level of interest rate describes how the corresponding slope changes in return and the slope of interest rates tells how something changes overtime if the slope is know the rate of change in interest rates can be easily calculated. At monthly level the interest rate is falling for the swap of same maturity and also on the basis of march to march the interest rate swap rates are falling, it would in turn benefit fixed income investors who expect rates to fall. In long term this relationship will benefit the One who bought variable rate on swap for payment purpose and the fall in interest rate will benefit that party because that party will pay on low rates after every year. The rate of the same maturity of interest rate swaps are falling in long run like for example the interest rate swap of 3 yr on 7/1/2000 is 7.14% and the same swap rate of 3 year on 7/1/2003 is 2.23% which also reflects that borrower who has taken out a long term loan on a three year maturity expects fall in interest rate which enables him to hedge its interest rate risk without having to change the loan term.

Macaulay duration is used to estimate the sensitivity of the bond price to the changes in interest rates. It also tells about the average term of maturity of the cash flows from the bond, in accordance with the calculated results.

The Macaulay duration of 1 year interest rate swap for 16 year period is 0.94 to 0.99 years in the 16 years time from 2000 to 2016,  For two year interest rate swap the Macaulay duration is 1.8 to 1.9 years , for three years interest rate swaps the Mduration is  2.66 to 2.94 years , for four years interest rate swap the Mduration for 16 years is 3.42 to 3.9 and the Mduration for other interest rate swaps can be seen in excel file one thing to note is that Mduration is less the actual tenor of interest rate swaps the Mduration provides the approximately the actual duration in which investor receive returns from swaps or in other case bonds. It gives the approximate changes in price of bonds not conclusive.

The monthly returns after the first year of entering into swap are increasing. In some years from 2000 to 2016 there are very few years where there is minor difference in the yield otherwise in  majority of years there are positive returns the average return for each swap is positive. These returns are greater enough to turn some negative return years into a positive one. investor will ultimately enjoy positive return or at least at worse it can use swap for hedging purpose.

average returns 0.21% 0.26% 0.32% 0.37% 0.41% 0.48% 0.57% 0.85%

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