Interest rate swaps – introduction
Introduction
Today there exists a vast interest rate swap market where trillions of pounds (in notional principal) of swaps of fixed-rate loans for floating-rate loans occur each year.
The market primarily consists of financial institutions and corporations who use the swap market to hedge more efficiently their liabilities and assets.
Many institutions create synthetic fixed or floating-rate assets or liabilities with better rates than the rates obtained on direct liabilities and assets.
We shall now go through some basic definitions relating to swaps and then work through a simple example.
Definition
A swap is an exchange of cash flows, CFs.
It is a legal arrangement between two parties to exchange specific payments.
There are many types of swaps including:
Interest Rate Swaps: Exchange of fixed-rate payments for floating-rate payments
Currency Swaps: Exchange of liabilities in different currencies
Cross-Currency Swaps: Combination of Interest rate and Currency swap
Credit Default Swaps: Exchange of premium payments for default protection
We shall concentrate in this article on interest rate swaps.
A Plain Vanilla or Generic Interest Rate Swap involves the exchange of fixed-rate payments for floating-rate payments.
Swap terms
Terms for this type of swap agreement would typically include:
1. Parties to a swap are called counterparties. There are two parties:
Fixed-Rate Payer
Floating-Rate Payer
2. Rates:
Fixed rate for instance, Treasury Bill rate plus basis points.
Floating rate is a benchmark rate: LIBOR.
3. Reset Frequency: Semiannual
4. Principal: No exchange of principal
5. Notional Principal (NP): Interest is applied to a notional principal; the NP is used for calculating the swap payments.
6. Maturity ranges between 3 and 10 years.
7. Dates: Payments are made in arrears on a semiannual basis:
Effective Date is the date interest begins to accrue
Payment Date is the date interest payments are made.
8. Net Settlement Basis: The counterparty owing the greater amount pays the difference between what is owed and what is received—only the interest differential is paid.
9. Documentation: Most swaps use document forms suggested by the International Swap Dealer Association (ISDA) or the British Banker’s Association. The ISDA publishes a book of definitions and terms to help standardize swap contracts.
Example of a plain vanilla interest rate swap
Fixed-rate payer pays 5.5% every six months
Floating-rate payer pays LIBOR every six months
Notional Principal = £10 million
Effective Dates are 1st March and 1st September for the next three years.
1. Effective dates 2. LIBOR 3. Floating-rate payer’s payment £* 4. Fixed-rate payer’s payment £** 5. Net interest received by Fixed-rate payer £Column 3 – Column 4
6. Net interest received by Floating-rate payer £Column 4 – Column 3
1/3/Y1 0.045
1/9/Y1 0.050 225,000 275,000 -50,000 50,000
1/3/Y2 0.055 250,000 275,000 -25,000 25,000
1/9/Y2 0.060 275,000 275,000 0 0
1/3/Y3 0.065 300,000 275,000 25,000 -25,000
1/9/Y3 0.070 325,000 275,000 50,000 -50,000
1/3/Y4 350,000 275,000 75,000 -75,000
* (LIBOR/2)(£10,000,000**(0.055/2)(£10,000,000)
If LIBOR is greater that 5.5%, then the fixed payer receives the interest differential.
If LIBOR is less than 5.5%, then the floating payer receives the interest differential.
Typically, an institution would use a swap agreement to hedge their current position with an existing asset. They could using the above example, create a fixed rate loan commitment from an existing variable rate position and vice-versa.
This type of agreement therefore allows institutions to very quickly change their positions to accommodate their views on where interest rate risks lie or, reposition their interest rate commitments to those they favour when availability in the conventional loan market is