Learn about the following:
What interest rate swaps are and how they work. How dealers make (and lose) money with swaps. How swaps can be used to manage risk. The key risks with swaps. How these risks can be controlled.
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1. How interest rate swaps work
2. Practical uses for swaps
3. Swaps and risk
4. Summary
5. Test
20th September 2009
When two parties agree to enter an interest rate swap (IRS) one party pays a fixed rate of interest and the other a variable rate. The variable rate is often referenced to Libor or Euribor. The interest payments are based on a notional amount, (with IRS no principal amount changes hands). In the market there are conventions for calculating the interest payments. For example USD IRS use an annual actual 360 interest rate calculation for the fixed payment and a quarterly or semi annual actual 360 calculation for the floating payment. Maturities are normally between 2 and 20 years but it is possible to trade swaps that have maturities exceeding 50 years. Customers using swaps to hedge can expect a dealer to quote a dealing spread. The dealer will want to receive a higher fixed rate than the one they pay. It's one way the dealer makes money from trading. Dealers will insist before trading that the appropriate documentation is signed. For swaps standard documentation is provided by the International Swaps and Derivatives Association (ISDA). This document is called a master agreement. It covers all swaps between the two parties. Individual transactions are then agreed by confirmation which refers to the master agreement.
14th October 2009
Gap reports are frequently used in firms to show the extent of the interest rate risk that is being run. They are sometimes referred to as interest rate repricing reports. If you look at the assets (investments) and the liabilities (funding) in a bank or building society balance sheet it is most unlikely that they will all be on the same interest basis. Some assets and liabilities are floating or variable rate. This means they are linked to Libor or Base rate. Some assets and liabilities are fixed rate. As a result the balance sheet will have a mixture of fixed rate and floating rate interest payments and receipts. When this happens the firm is exposed to a type of market risk called interest rate risk. When interest rates change the value of the balance sheet can alter. It may work in your favour it may work against you. The main difficulty is the uncertainty you face and that's something you need to manage. A gap report measures this risk. Let's see how.