Swapmagic
This explainer is based on Worst Bank Scenario by Hester Bais and Wink Sabée.
Original situation: Firm \(M\) pays variable rate on a loan to the bank. The bank pays pension fund \(P\) 2.5% for funding debt.
Firm \(M\) wants to protect against rising interest rates, while the pension fund \(P\) wants to protect against declining interests rate.
Step 1: Introduce a variable to fixed swap between firm (\(M\)) and intermediary \(I\):
Step 2: Introduce a variable to fixed swap between pension fund and intermediary \(I'\):
Complete picture
Observations
- Firm \(M\) pays a fixed rate of 4% and the pension fund gets a fixed rate of 2.25%.
- The bank gets 50 basis points spread, but manages to shift interest risk off-balance: to \(M\) and \(P\).
- The bank has now become a broker, with zero exposure to interest rate risk.
- The intermediaries (\(I\) and \(I'\)) get 100bp from \(M\) and 25bp from \(P\).
The bank can do better!
Merge the bank with the intermediaries into conglomerate \(BI\):
Wrapped up, at the consolidated bank level it looks like this.
All profits go to the bank, all risks are now off-balance. Obviously netting is an issue as well as collateral.