Before we go on to explore Interest rate swaps, let us get a rough idea of the playing field. Think for a moment that Intel is setting up a bunch of fabrication plants and research labs in China and needs a 1 billion US$ loanfor that purpose. Let us say that it approaches Citibank and asks for a quote on how much interest that it will charge for this loan. For Citibank to lend 1 billion US$ to 1 single customer is a huge risk. No bank would normally take such a huge risk. What if Intel went bankrupt and was unable to pay back the loan amount(principal)?

Therefore, Citibank would normally invite other large Corporate banks to contribute towards this sum of 1 billion dollars.Let us also suppose Citibank calls up Barclays, Credit Suisse, ABN Amro, Royal Bank of Scotland and Deutsche Bank and that these banks express interest in taking part of this loan exercise. Thus, all these banks would jointly come up with the required 1

billion dollars to be lent to Intel. This set of banks is called a syndicate and this type of a loan is called a Syndicated Loan. Normally, a single bank take the lead role in this process and is known as the lead manager.In this case, the lead manager would normally be Citibank which would contribute a large portion of this 1 billion dollars.Needless to say, the interest payments made by Intel would be shared by the syndicate member banks in the ratio in which they contributed to the principal amount ( In this case,1 billion dollars).

Suppose that this syndicate of banks decides that they would charge Intel an annual interest of 8.5% per annum (per year) payable annually. Also suppose that Intel would like to pay back this money(1 billion dollars) over 5 years. Thus, normally Intel would pay the syndicate of banks $85 million every year for the next 5 years. It would then pay back the principal amount of $1 billion(at the end of the 5 year period).

Now suppose that another large bank, say Morgan Stanley tells Intel that it could lead another syndicate and lend Intel the same 1 billion dollars at 8.48%. The difference in interest rates seems to be trivial, doesn’t it? What would be the interest payable to this syndicate by Intel? If you do the number crunching, you would find that the interest payable annually would turn out to be 84.8 million dollars. This is a difference of $200,000 per year which adds up to $ 1 million over 5 years ! Therefore, we can see clearly that we need a better unit to represent interest rates.

To solve this problem, banks normally represent interest rates in terms of a unit known as “basis point”. 1 basis point is 0.01 percent i.e 0.0001 i.e 1/10,000 . Thus, a different of 0.02% in interest rates is a difference of 2 basis points (also known as “pips” in this case). Alright, we have just seen how large corporations borrow from Corporate banks at fixed interest rates. Let us now see what floating rates are. Floating rates, as the term implies, are rates that change on a day to day basis. When banks lend each other money, they charge interest. The rate of interest they charge varies from day to day and is usally pegged to a benchmark rate such as the LIBOR. LIBOR stands for London Inter Bank Offered Rate. This is the rate at which banks in London

lend to each other(And this figure changes on a daily basis). However, this very rate can be used as a benchmark to base floating rate loans, i.e Citibank may lend Intel 1 billion dollars at a floating rate of LIBOR + 50 bases points. Thus, at the end of 1 year, suppose the LIBOR rate is 6.5% per annum, the interest that Intel has to pay is (6.5+0.5) % of $ 1 billion i.e 70 million$. Suppose the LIBOR value at the end of year 2 is 6% p.a, Intel would have to pay only 65 million
dollars as interest for year 2.

When would Intel choose to borrow on a floating rate? Think for a moment, what would happen if the LIBOR rate goes up? Intel would have to pay a higher amount of interest. What would happen if the LIBOR rate falls? Intel would have to pay a lower amount of interest. Thus,generally speaking, a company would choose to borrow on floating rates if it thinks that the interest rates are going to drop.

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