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Structure
In an interest rate swap, each
counterparty agrees to pay either a
fixed or floating rate denominated in a
particular currency to the other
counterparty. The fixed or floating rate
is multiplied by a notional principal
amount (say, USD 1 million). This
notional amount is generally not
exchanged between counterparties, but
is used only for calculating the size of
cashflows to be exchanged.
Types
Being OTC instruments interest rate
swaps can come in a huge number of
varieties and can be structured to meet
the specific needs of the
counterparties. By far the most
common are fixed-for-floating,
fixed-for-fixed or floating-for-floating.
The legs of the swap can be in the
same currency or in different
currencies. (A single-currency
fixed-for-fixed rate swap is generally Normally the parties do not swap payments directly, but rather each sets up a separate
not possible; since the entire cash-flow swap with a financial intermediary such as a bank. In return for matching the two parties
together, the bank takes a spread from the swap payments (in this case 0.30% compared
stream can be predicted at the outset
to the above example)
there would be no reason to maintain a
swap contract as the two parties could
just settle for the difference between the present values of the two fixed streams; the only exceptions would be where
the notional amount on one leg is uncertain or other esoteric uncertainty is introduced).
Other variations
A number of other variations are possible, although far less common. Mostly tweaks are made to ensure that a bond
is hedged "perfectly", so that all the interest payments received are exactly offset by the swap. This can lead to swaps
where principal is paid on one or more legs, rather than just interest (for example to hedge a coupon strip), or where
the balance of the swap is automatically adjusted to match that of a prepaying bond (such as RMBS Residential
mortgage-backed security)
Uses
Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today,
interest rate swaps are used to hedge against or speculate on changes in interest rates.
Speculation
Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates
or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase
cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed
interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.
Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying levels of
creditworthiness in companies, there is often a positive quality spread differential which allows both parties to
benefit from an interest rate swap.
The interest rate swap market is closely linked to the Eurodollar futures market which trades at the Chicago
Mercantile Exchange.
where C is the swap rate, M is the number of fixed payments, P is the notional amount, ti is the number of days in
period i, Ti is the basis according to the day count convention and dfi is the discount factor.
Similarly, the value of the floating leg is given by the present value of the floating coupon payments determined at
the agreed dates of each payment. However, at the start of the swap, only the actual payment rates of the fixed leg
are known in the future, whereas the forward rates (derived from the yield curve) are used to approximate the
floating rates. Each variable rate payment is calculated based on the forward rate for each respective payment date.
Using these interest rates leads to a series of cash flows. Each cash flow is discounted by the zero-coupon rate for the
date of the payment; this is also sourced from the yield curve data available from the market. Zero-coupon rates are
used because these rates are for bonds which pay only one cash flow. The interest rate swap is therefore treated like a
series of zero-coupon bonds. Thus, the value of the floating leg is given by the following:
where N is the number of floating payments, fj is the forward rate, P is the notional amount, tj is the number of days
in period j, Tj is the basis according to the day count convention and dfj is the discount factor. The discount factor
always starts with 1. The discount factor is found as follows:
[Discount factor in the previous period]/[1 + (Forward rate of the floating underlying asset in the previous
period × Number of days in period/360)].
(Depending on the currency, the denominator is 365 instead of 360; e.g. for GBP.)
The fixed rate offered in the swap is the rate which values the fixed rates payments at the same PV as the variable
rate payments using today's forward rates, i.e.:
[3]
Therefore, at the time the contract is entered into, there is no advantage to either party, i.e.,
Risks
Interest rate swaps expose users to interest rate risk and credit risk.
• Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-for-floating swap, the party
who pays the floating rate benefits when rates fall. (Note that the party that pays floating has an interest rate
exposure analogous to a long bond position.)
• Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money,
then that party faces credit risk of possible default by another party.
Market size
The Bank for International Settlements reports that interest rate swaps are the second largest component of the global
OTC derivative market. The notional amount outstanding as of June 2009 in OTC interest rate swaps was $342
trillion, up from $310 trillion in Dec 2007. The gross market value was $13.9 trillion in June 2009, up from $6.2
trillion in Dec 2007.
Interest rate swaps can now be traded as an Index through the FTSE MTIRS Index.
References
[1] " Interest Rate Swap (http:/ / demonstrations. wolfram. com/ InterestRateSwap/ )" by Fiona Maclachlan, The Wolfram Demonstrations
Project.
[2] Duncan Campbell-Smith, "Follow the Money: The Audit Commission, Public Money, and the Management of Public Services 1983-2008",
Allen Lane, 2008, chapter 6 passim.
[3] "Understanding interest rate swap math & pricing" (http:/ / treasurer. ca. gov/ CDIAC/ publications/ math. pdf). California Debt and
Investment Advisory Commission. 2007-01. . Retrieved 2007-09-27.
• Pricing and Hedging Swaps, Miron P. & Swannell P., Euromoney books 1991
External links
• Bank for International Settlements (http://www.bis.org/statistics/derstats.htm) - Semiannual OTC derivatives
statistics
• Investopedia - Spreadlock (http://www.investopedia.com/terms/s/spreadlock.asp) - An interest rate swap
future (not an option)
• Basic Fixed Income Derivative Hedging (http://www.financial-edu.com/
basic-fixed-income-derivative-hedging.php) - Article on Financial-edu.com.
• Hussman Funds - Freight Trains and Steep Curves (http://www.hussmanfunds.com/html/debtswap.htm)
• Interest Rate Swap Calculator (http://www.basicfixedincome.org/#Swaps)
• "All about money rates in the world: Real estate interest rates" (http://www.worldwideinterestrates.com/
realestate/real_estate_interest_rates.htm), WorldwideInterestRates.com
Article Sources and Contributors 7
License
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