INTEREST RATE SWAP -DERIVATIVE INSTRUMENT

3rd august 2010 : ECONOMIC TIMES

INTEREST
RATE SWAP
What is an interest rate swap?
An interest rate swap is an over-the-counter (OTC) derivative instrument available in the currency market where counter parties can exchange a floating payment for a fixed payment and vice-versa related to an interest rate. Financial institutions going for foreign borrowings usually buy interest rate swaps to hedge their interest rate exposure due to fluctuating interest rates.
These were originally created to allow multinational companies to evade exchange controls. Today, they are used to hedge against or speculate on changes in interest rates.
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 floatingfor-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.
How does it work?
In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a particular currency to the other counter party. The fixed or floating rate is multiplied by a notional principal amount (say, $1 million). This notional amount is generally not exchanged between counter parties, but is used only for calculating the size of cash flows to be exchanged.
The most common interest rate swap is one where one counter party A pays a fixed rate (the swap rate) to counter party B while receiving a floating rate (usually pegged to a reference rate such as LIBOR — London Inter Bank Offered Rate).
A pays fixed rate to B (A receives floating rate)
B pays floating rate to A (B receives fixed rate).
Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 3.784%, in exchange for periodic floating interest rate payments of LIBOR + 70 bps (0.70%). There is no exchange of the principal amount and that the interest rates are on a notional principal amount. The interest payments are settled in net. The fixed rate (3.784% in this example) is referred to as the swap rate.
What are the different types of swaps?
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 counter parties. By far the most common are fixed-for-floating, fixedfor-fixed or floating-for-floating. The legs of the swap can be in the same currency or in different currencies. The above example is a specimen of fixed-for-floating swap. Fixed-for-fixed works the same way except that there is no change in the rate used during the date of payment, as does floating-for-floating swap.