In Australia, the Bank Bill Swap Bid Rate (BBSY) is the institution that sets the interest rate used in the financial markets for the pricing and valuation of Australian dollar securities. Its index rates of interest are used by banks to price the borrowing of money.
Think of the BBSY as the Aussie LIBOR. The BBSY establishes the rate that high quality banks (those with high credit ratings) charge each other for short-term debt financing.
An interest rate swap is a contract entered into by two banks which want to swap streams of interest payments with each other. One bank swaps fixed interest payments in exchange for floating interest payments, dependent on the movement of the BBSY. Reason: one company is betting that the floating interest rate will make more money for them, the other is betting that fixed interest is preferable.
For example: Two banks, Fair Dinkum and Ema Chisit, enter into an interest rate swap. Ema Chisit pays fixed payments to and receives floating payments from company Fair Dinkum. The semi-annual fixed interest rate is 3% and the floating rate is BBSY + 0.35%, to be paid on a semi-annual basis. Payments are to be swapped on a principal amount of $1 million. On the day the payment amount is calculated, Ema Chisit will pay ½ x 3% x $1 million = $16,005 to Fair Dinkum. Assuming the BBSY is 1.90%, Fair Dinkum will remit ½ x (2.90% + 0.35%) x $1 million = $16,250 to Ema Chisit. Floating rate wins.
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