18 Questions
What is the primary purpose of an interest rate swap?
To exchange fixed interest payments for floating rate payments
What is the notional amount used for in an interest rate swap?
To calculate the cash flows
What is the fixed rate payer's role in an interest rate swap?
To make fixed interest payments
What is a key feature of a basis swap?
Floating rates
What is the typical basis for the floating rate in an interest rate swap?
LIBOR + Spread
How is a basis swap typically quoted?
As a spread (basis points)
How often are payments typically made in an interest rate swap?
Quarterly, semi-annually, or annually
What is the term length of an interest rate swap?
Between 2 and 30 years
What is one of the primary uses of cross-currency basis swaps?
Swapping liquidity between currencies
What is an example of a basis swap?
3-M USD T-Bill vs. 3-M USD LIBOR
Why might a company use a basis swap?
To eliminate basis risk
What is the primary purpose of most swaps?
To hedge or manage risk
What is a characteristic of the payment frequencies in a basis swap?
The frequencies can be different
What is the typical duration of a swap contract?
1 – 5 years
What is the role of a swap dealer in a swap trade?
To offset the swap through an inter-dealer broker
What is a characteristic of most swap contracts?
They are tailor-made contracts
What is the requirement for the two payment streams in a swap contract?
They must have the same NPV
What is the role of the inter-dealer broker in a swap trade?
To act as an intermediary between the swap dealer and the counterparty
Study Notes
- An interest rate swap is an exchange of fixed interest payments for floating rate payments between two parties, typically with a swap dealer (swap bank) involved.
- In an interest rate swap, interest payments are netted, and the party that owes more in interest at a settlement date makes a payment equal to the difference to the other party.
- The net fixed rate payment made (or received) by the fixed payer is calculated as [Swap Fixed Rate – (Floating Rate)] x (# Days / 360) x Notional Principal.
- Interest rate swaps have key features including a term of 2-30 years, a notional amount used to calculate cash flows, payment frequency of quarterly, semi-annually, or annually, and a floating rate based on LIBOR.
- A swap contract is a derivative in which two counterparties exchange cash flows (known as “legs”) of equal expected values at periodic intervals, often with one leg being a fixed payment and the other being a floating payment.
- Swap terms specify the duration and frequency of payments, and most swaps are tailor-made contracts traded in an OTC-type environment between financial institutions or market makers.
- Swaps are usually used for hedging, speculating, or managing risk, and the NPV of both payment streams must be the same.
- Basis swaps are used to swap liquidity, and they involve different reference rates, such as 3-month LIBOR, 1-month LIBOR, 6-month LIBOR, prime rate, etc.
- Basis swaps have key features including floating rates that should be different, quotation as a spread (basis points), and usage primarily for swapping liquidity across currencies.
- Cross-currency basis swaps (CCBS) involve exposure to currency fluctuations, and they are used to lock in exchange rates for a set period of time.
- Basis swaps can be used to eliminate basis risk, limit interest rate risk, speculate, and lock in exchange rates.
Test your knowledge of basis swaps in finance, including types such as tenor basis swaps, cross currency basis swaps, and more. Learn about different indexes, yield curves, and exposure to currency fluctuations. Master the concepts of floating rates, quotations, and key features of basis swaps.
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