San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

Interest Rate Swaps

Most financial market instruments are of such ancient lineage that the initial development is lost in history, but the birth of the interest rate swap is known precisely. The World Bank (more properly the International Bank for Reconstruction) borrows funds internationally and loans those funds to developing countries for construction projects. It charges its borrowers an interest rate based upon the rate it has to pay for the funds. The World Bank had a definite motivation to seek the lowest cost borrowing it could find. In 1981 the relevant interest rate in the U.S. was at 17 percent, an extremely high rate due to the anti-inflation tight monetary policy of the Fed under Paul Volcker. In West Germany the corresponding rate was 12 percent and Switzerland 8 percent. The problem for the World Bank was that the Swiss government imposed a limit on World Bank could borrow in Switzerland. The World Bank had borrowed its allowed limit in Switzerland and the same was true of West Germany.

IBM at that time, 1981, had large amounts of Swiss franc and German deutsche mark debt and thus had debt payments to pay in Swiss francs and deutsche marks. IBM and the World Bank worked out an arrangement in which the World Bank borrowed dollars in the U.S. market and swapped the dollar payment obligation to IBM in exchange for taking over IBM's Swiss franc and deutsche mark obligations.

After the World Bank and IBM showed the way the market for swap grew by leaps and bounds. Now the amount of the funds involved in the swap market is many trillions of dollars.

The standard, sometimes called vanilla, swap is when one party holds fixed interest rate obligations and the other holds floating rate obligations. The party holding fixed rate obligations may think the short term interest rates are going to go down whereas the party holding the floating rate obligation may think the interest rate will go up. Then the two parties may be willing to exchange responsibilities for the interest and repayment.

While it might seems that it would be unusual to find two parties who want to do the opposite things the surprising thing is that any two parties facing different combinations of fixed and floating interest rates one will have a comparative advantage in fixed rate borrowing the other in floating rate borrowing. The calculator below makes the determination.

Calculator for
Interest Rate Swaps
 Borrower 1 Borrower 2
Fixed Rate (%)
Floating Rate:            LIBOR + (%)
Comparative Advantage Borrowing:

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