Interest Rate Swaps I

What is an Interest Rate Swap, (IRS)?

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.

How are the interest amounts calculated?

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.

What is the longest interest rate swap you can do?

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.

What documentation is used for interest rate swaps?

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.

What can interest rate swaps be used for?

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.

How are interest rate swaps used for trading?

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.

Can you lose money with interest rate swaps?

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.

First Published by Barbican Consulting Limited 2006