Interest rate swaps.pdf (93kb)

An interest rate swap is an over-the-counter derivative transaction. The two parties to the trade periodically exchange interest payments. There is no principal exchange.

One party pays a fixed rate of interest, the other pays a floating rate of interest. The fixed interest payment remains unchanged throughout the life of the deal. It is paid annually, semi-annually or quarterly in arrears.

The floating interest is paid on a three or six monthly basis. Because it is reset using the relevant Libor rate it will vary depending on short term interest rates. It too is paid in arrears.

The interest amounts are based on the principal amount which is sometimes referred to as the nominal.

The interest payments are calculated using the method that is agreed between the parties. There are conventions. For example USD IRS use an annual actual 360 interest rate calculation for the fixed interest and a quarterly or semi-annual actual 360 calculation for the floating interest.

The major currencies have very liquid interest rate swap markets. Interest Rate Swaps can have maturities of between 2 and 20 years but it is possible to trade swaps that have maturities exceeding 50 years. If you intend to do long dated deals you may be asked to collateralise the transactions.

The standard documentation is the International Securities Dealers Agreement, (ISDA master agreement). This is negotiated and signed by both parties. Confirmations then cover individual transactions and refer to the master agreement.

Interest rate swaps can be used to manage interest rate risk, an example follows. A bond issuer can sell a fixed rate bond to an investor. The fixed funding cost of the borrower is then swapped to a floating rate using an IRS.

The investor obtains a fixed rate asset; this may suit interest rate expectations or match investment criteria. But many borrowers prefer to fund on a floating rate basis with the cost of borrowing expressed as a spread over or under Libor. By using a swap the issuer and investor can both get the interest basis they want.

The net floating rate cost of funds to the issuer, (Libor plus/minus), is dependent on the difference between the fixed cost of funding and the swap rate. If the fixed cost of funds is below the equivalent swap rate then the floating rate funding cost is Libor less a margin. If the fixed cost of funds is above the equivalent swap rate then the floating rate funding cost is Libor plus a margin.

If a trader anticipates interest rates to fall he could receive fixed interest on a swap and pay floating. If rates do fall the trader will now be receiving a higher interest rate than the market rate. The interest rate swap will have a positive value. But the trader has taken risk. This could have gone wrong, rates could have risen.

Interest rate swaps can also be used to trade the shape of the yield curve. This can include the difference between the 2 year swap rate and the 5 year rate, the 2 year rate and the 10 year rate, the 5 year rate and 10 year rate and the 10 year rate and the 30 year rate. If the trader thinks the relative yields between two parts of the curve are "out of line" he can receive fixed interest in one maturity and pay fixed in the other.

The nominal amounts of the two swaps are adjusted by the duration of the swaps. (This means the nominal amount of the near dated swap is greater than that of the far dated swap). This type of trade will benefit the trader if the slope of the yield curve moves as expected. A variation on this trade takes three points on the yield curve trading the spread differential between centre point and the outside two points.

You can make and lose money with interest rate swaps. The current value of a swap is called the mark-to-market value. This is what the swap is worth using current market interest rates. For banks daily valuation is important. It provides profit and loss figures, shows whether hedging is effective and provides information for collateral support. And should you need to cancel or break a swap before it has matured the valuation will provide the basis of the cost you pay or the benefit you receive.

If it is in your favour you should receive a payment from your counterparty that equals the market value. If you are losing money on the swap you will have to pay the market value to your counterparty. This has a practical significance.

Let's suppose you used a swap to convert floating rate funding to a fixed rate and that funding was linked to the purchase of an asset.

If you sell the asset and make money you will be left with the swap. If interest rates have fallen you will be losing money on the swap. You will have to pay your counterparty to cancel it. You need to include this cost in the realisation of your asset.

If you don't like the cost of cancellation do not fall into the trap of leaving the interest rate swap in place hoping that it will improve. Otherwise your hedge will become a speculative trade.

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.

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.