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The notional is purely a reference amount. For the vast majority of derivatives the notional amount is never exchanged (cross-currency basis swaps being a notab
by retube 11y ago
The notional is purely a reference amount. For the vast majority of derivatives the notional amount is never exchanged (cross-currency basis swaps being a notable exception).
E.g a simple interest rate swap: I agree to pay you 2% per annum on a reference notional of 100m for 10 years, and in exchange you pay me libor referencing the same notional. At the end of first year let's say libor fixes at 1.98%. Hence I pay you a net 0.02% (2% - 1.98%) of 100m, i.e 20,000. We do this every year for 10 years.
It is just a way to hedge interest rate exposure - e.g I have borrowed 100m paying a Libor-linked interest rate and don't want to run the risk that Libor spikes to 10% or whatever.
There's nothing complicated about this, at least in principle. Derivatives just allow people to hedge out exposures they don't want.
- jackcosgrove 11y agoI see. So if you pay cash now you are vulnerable to interest rate swings. Whereas if you use leverage to spread the term of your investment out, you can average the interest rate across the business cycle and achieve more predictable behavior. Is that correct?
- lordnacho 11y agoI think point of the example was not to say that you could use leverage. You're borrowing the same amount that you're lending. The idea of the interest rate swap is simply that some entities prefer to lock in a rate, others prefer to have it float. So they swap those risks.
- JackFr 11y agoConsider that borrowing 10 year money at the 6-month LIBOR rate is equivalent to borrowing at LIBOR for 6 months and rolling the debt 19 times. The swap market provides a linkage between the money market ( borrowing < 1 year) and the capital market (borrowing > 1 year), and allows one to borrow (or lend) where the comparative advantage is better. The 10 year swap rate is then a market number which represents the relative demand (and supply) within the money & capital markets.