IR SWAP
An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. As such, interest rate swaps are very popular and highly liquid instruments.
Structure
In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cashflows to be exchanged.
The most common interest rate swap is one where one counterparty pays a fixed rate (the swap rate) while receiving a floating rate (usually pegged to LIBOR). Consider the following swap in which Party A agrees to pay Party B periodic interest rate payments of LIBOR + 50 bps (0.50%) in exchange for periodic interest rate payments of 3.00%. Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. if LIBOR + 50 bps is 1.20% then Party A receives 1.80% and Party B pays 1.80%). The fixed rate (3.00% in this example) is referred to as the swap rate.[1]
At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.
Types
Fixed-for-floating rate swap, same currency
Fixed-for-floating rate swap, different currencies
Floating-for-floating rate swap, same currency
Floating-for-floating rate swap, different currencies
Fixed-for-fixed rate swap, different currencies
Uses
Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.
Hedging
Today, interest rate swaps are often used by firms to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line with management's appetite for interest rate risk. For example, Fannie Mae uses interest rate derivatives to hedge its cash flows. The products it uses are pay-fixed swaps, receive-fixed swaps, basis swaps, interest rate cap and swaptions, and forward starting swaps. Its "cash flow hedges" had a notional value of $872 billion at December 31, 2003, while its "fair value hedges" stood at $169 billion (SEC Filings) (2003 10-K page 79). Its "net value" on "a net present value basis, to settle at current market rates all outstanding derivative contracts" was (7,712) million and 8,139 million, which makes a total of 6,633 million when a "purchased options time value" of 8,139 million is added.
What Fannie Mae doesn't want is for example a wide "duration gap" for a long period. If rates turn the opposite way on a duration gap the cash flow from assets and liabilities may not match, resulting in inability to pay the bills on liabilities.
Speculation
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 floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.
Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to benefit from an interest rate swap.
The interest rate swap market is closely linked to the Eurodollar futures market which trades at the Chicago Mercantile Exchange.