Interest Rate Swap Concept

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.