Credit Swaps explained like I'm 5 in 10 tweets 👇
1) I sell ships from India. I've sold 100 ships to a shipping company in Japan.
The shipping company can't pay me at once so they plan to repay me within 10 years with Japanese interest rates.
2) To make these 100 ships, I borrowed money from an Indian bank which I plan to repay in the next 10 years with the money I get from the Japanese company annually.
3) Now, if Japanese interest rates go down, I collect less money from my customer.
And if Indian interest rates go up, I will have to pay more money.
This is a "worst case scenario" for me as I won't be able to my loan back.
3) So, I take an "insurance" for this worst-case scenario in the form of an Interest Rate Swap.
I pay someone an amount based on the Japanese interest rate (plus a fee), and they pay me an amount based on the Indian interest rate.
We basically pay each other's interest rates.
4) This allows me to pay back the Indian loan's interest rate at any cost.
Now, a "worst case scenario" is actually good for me.
I might make a profit because I pay a lower Japanese interest rate and get a higher Indian interest rate.
5) If "worst case scenario" is good, then "best case scenario" should be bad, right?
Not really.
6) If Japanese interest rates go up (I collect more money), and Indian interest rates go down I have to pay less money).
I lose money on the interest swap I made but I'd still be able to repay my loan.
7) This is called hedging (your bets).
When you have a risk that your interest rates might move in undesirable directions you mitigate the risk by bringing in a third-party who is responsible for paying you the interest rate you need to pay back the loan.
8) Alternatively, you might have to worry about repayments instead interest rates, but you are concerned that your repayments will go up if interest rates go up.
In this case, you might buy a different kind of a swap.
9) You swap a fixed $$$ for a variable $$$.
The variable $$$ will be tied to your repayments, and the fixed $$$ will be agreed at the start.
Same funda as the interest rate swap, only in this case you do it to make sure you make your repayments back.
10) Fin.
On which other finance dude bro topic, should I make an ELI5 next? Lemme know👇
Shriman (✿◡‿◡)
@thevisahan
odd jobs @stoahq • comp sci + philosophy @ashokauniv • i post pics of my cat
