Question

Explain with diagram how can bank make profit when arranging an Interest Rate Swaps

Answer 1

As per my understanding:

Following example will help to clarify your doubt

ABC Company and MNO Bank enter into one-year interest rate swap with a nominal value of $10 million. ABC offers MNO a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1%, LIBOR is 4% At the end of the year, ABC will pay MNO bank $500,000 (5% of $10 million). If the LIBOR rate is trading at 3.75%, MNO Bank then will have to pay ABC Company $475,000 (4.75% of $10 million, because of the agreement to pay LIBOR plus 1%).

Therefore, the value of the swap to ABC and MNO Bank is the difference between what they receive and spend. Since LIBOR ended up lower the MNO bank won out with a gain of $25,000, while ABC realizes a loss of $25,000.