Interest Rate Swaps

A swap is an agreement between two parties to exchange a series of payments that are determined according to different methods. Swaps necessarily have two participants commonly known as counterparties. Each counterparty has prescribed responsibilities to the other and recourse provisions if the counterparty fails to satisfy any of its responsibilities. The key objective of an interest rate swap is the modification of an organization's cash flow pattern. Perhaps the simplest cash flow pattern characteristic of swaps is an obligation to regularly pay some fixed amount of cash. That obligation is similarly characteristic of a fixed interest rate bond. The other cash flow pattern that characterizes a swap is an obligation to regularly pay a variable amount of cash whose magnitude is determined by an exogenous parameter such as the London Interbank Offer Rate of interest. Both of these payment streams are specified in the term of interest rates. Furthermore, those rates are applied to some notional amount of money known as the notional principal to determine the actual cash payments. The two payment streams are commonly known as the swap's legs. The notional amount of a swap, sometimes called its notional principal, is conceptually similar to the principal of a bond. Although payments will be exchanged according to the provisions of each swap leg, no similar exchange is made of principal or notional amount for interest rate swaps. When a fixed rate of payments is exchanged for a floating rate of payments the swap is known as a coupon swap. Conversely, it is possible for both legs of the swap to have floating rate payments with two different reference rates. For example one could be tied to LIBOR and the other could be tied to U.S. Treasury bills. Such swaps are known as basis swaps.
Since interest rate swaps have no actual exchange of principal, they use the idea of principal or rather a notional principal to calculate the amount of periodic payments. For example if a swap's notional principal were $1,000,000 a fixed payment of 10% would mean an annual payment of $100,000. Similarly, a floating payment of 9% on that same swap agreement would imply an annual $90,000 payment.

Distinguishing between counterparties

Although no principal is actually exchanged in interest rate swaps, one counterparty is affected by the swap as though it issued a fixed rate bond and purchased a floating rate bond. Concurrently, the other counterparty is affected as though it issued a floating rate bond and purchased a fixed rate bond. The counterparty obligated to periodically pay a fixed amount to the other is commonly known as the swap payer. Conversely, the counterparty who receives the periodic fixed payment is known as the swap receiver. Thus, the terms payer and receiver exclusively designate the swap participants according to their actions relative to the fixed rate leg of the swap. The attitude of each counterparty follows logically from these characteristics. The fixed rate payer is said to be long or to have bought the swap. The floating rate payer is said to be short or to have sold the swap. Since the payer of a swap will pay the fixed rate, the payer prefers the lowest rate possible. Conversely, the receiver of a swap will get the fixed rate payment and consequently prefers the highest rate possible.

Timing of payments

Typically, a bond is issued for a prescribed number of years known as its maturity time with an associated interest rate that remains constant. Swaps follow the same logic. The schedule of payments for an interest rate swap commonly also allows for updating the floating interest rate to match its underlying reference rate. Thus this schedule is known as the swap's reset frequency. Although the interest rates are specified as annual rates, traditionally payments are made semi-annually. The interest rate used to determine the semi-annual payment is one half of the stated annual rate. Thus, if an annual interest rate for a bond were specified as 6%, the semi-annual payment would employ 3% to determine the payment amount. Furthermore, bonds are commonly denominated in $1,000 amounts known as the bond's face value. The consequent semi-annual payment of this combination is therefore $30 per bond.

The price of a swap

Since a coupon swap can be considered as a portfolio containing a long or short position in a floating rate note and a short or long position in a fixed coupon bond, its value can be estimated by the difference between the present values of the fixed coupon bond and that of the floating rate note. Normally, participants wish to enter swap agreements without any exchange of funds. Thus, swaps are sometimes called self funding or zero cost agreements. A further consequence of this zero value is that these agreements do not appear on the firm's balance sheet. Thus they are also known as off-balance sheet activities. This pricing is accomplished by setting the prices of the long and short equivalent positions equal to each other.
In the secondary market the value of a swap to the fixed rate payer or long side is the value of the floating rate note component minus the value of the fixed rate component.
Swaps are traded on a yield basis. For coupon swaps quotes are given in terms of the fixed rate payment that must be made. The internal rate of return that equates the present value of fixed payments to the present value of floating payments gives the price of an interest rate swap. In the U.S. swaps with terms over three years are quoted as a spread over the equivalent U.S. Treasury bond's yield to maturity. Thus, the actual swap price is the sum of the bond's yield to maturity plus the swap spread. The full yield is quoted for shorter term swaps.

Risks of swaps

Participants in interest rate swaps incur two forms of risk. One is known as interest rate risk and the other credit risk.

Interest rate risk

Credit risk

Since the principal in a swap agreement is notional and not actual, the entirety of credit risk derives from periodic exchanges. Furthermore, since these payments are netted the risk is asymmetric. Only the counterparty expecting to receive a payment is exposed to credit risk. Of course over the live of a swap agreement this risk can shift back and forth between counterparties.

Rationale for swaps

Comparative advantage

Complete markets

Low cost risk management alternative

Taxation and regulation arbitrage

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License