Interest Rate Swap Concept

Study Notes

Interest Rate Swap

An interest rate swap is an exchange of a fixed interest rate payment and a floating interest rate payment based on a notional principal amount.
The notional principal amount can be a loan or bonds.
The swap involves two legs, which are the two exchanges of cash flows.
It is the most common type of swap.

Example of Interest Rate Swap

A 3-year swap between Microsoft and IBM, where Microsoft agrees to pay IBM a fixed interest rate of 5% yearly on a principal of $100 million, and IBM agrees to pay Microsoft the 6-month LIBOR rate on the same principal.
Microsoft is the fixed-rate payer, and IBM is the floating-rate payer.
Payments are exchanged every 6 months, and the 5% interest rate is quoted semiannually.

Cash Flows of Interest Rate Swap

In 6-2020, Microsoft received $2,100,000 (100,000,000 × 4.70% × 0.5) and paid $2,500,000 (100,000,000 × 5% × 0.5).
The net cash flow is -$400,000 (2,100,000 - 2,500,000), which means Microsoft had to pay $400,000 to IBM.

Market Makers and Hedging

Market makers are prepared to enter into a swap without having an offsetting swap with another counterparty.
They must carefully quantify and hedge the risks they are taking.
They can use bonds, forward rate contracts, and interest rate futures for hedging.

Swap Rate

The swap rate is used as a benchmark for ask and bid rates.
It is calculated by the equation: Swap Rate = (Ask + Bid) / 2.
The swap rate for a 2-year maturity swap is approximately 3.98%.

Currency Swap

A fixed-for-fixed currency swap involves exchanging principal and interest payments at a fixed rate in one currency for principal and interest payments at a fixed rate in another currency.
The principal amounts in each currency are usually exchanged at the beginning and at the end of the life of the swap.

Example of Currency Swap

Microsoft receives 4.80% on bonds and receives LIBOR under the swap terms, and pays 5% under the swap terms.
The swap transforms an asset earning a fixed interest rate into an asset earning a floating interest rate.
IBM receives LIBOR minus 20 basis points on its investment, pays LIBOR under the swap terms, and receives 5% under the swap terms.
The swap transforms an asset earning a floating interest rate into an asset earning a fixed interest rate.

Example of Interest Rate Swap in Case of Bond (Asset)

A manager of a large portfolio wants to sell long-term bonds paying a 6% coupon rate and replace them with short-term or floating-rate issues.
However, replacing the portfolio every time the forecast for interest rates is updated would be expensive in terms of transaction costs.
The manager can use an interest rate swap to hedge the risk.

Description

Understand the concept of Interest Rate Swap, a financial derivative where two parties exchange fixed and floating interest rate payments based on a notional principal amount. Learn about the legs of the swap and its common types. This quiz will test your knowledge of Interest Rate Swap with examples.