An interest rate swap is a contractual agreement between two parties to exchange interest payments. The most common type of interest rate swap arrangement is one in which Party A agrees to make payments to Party B based on the fixed interest rate, and Party B agrees to pay party A based on the floating interest rate.
In this context, vanilla swap is widely used in the market. Financial institutions with good credit ratings offer swap facilities to clients and charge fees from brokers. Risk is diversified through dispersal of swap transactions among many clients. Almost all cases, the floating rate is tied to a reference rate.
The interest rate swaps are contracts between two parties related to exchange of interest rates. These are typically forward contracts, where the parties can tailor it to decide the specific date and price. In this case, as per the principal amount, the exchange of interest is done.
In the process of interest rate swap valuation, a fixed rate is exchanged for floating rate by taking advantage of the rate fluctuations in the financial market in order to obtain lower rates. Without swap, this would nit have been possible.
A plain vanilla Swap is the most common one in this field, since they are the simplest of them all where fixed rate is exchanged against floating rate. Thus, they are basically exchanging cash flows against each other, and the contract is customized. The exchange in done, based on LIBOR (London Inter-Bank Offered Rate).
LIBOR changes daily and is considered to be the benchmark for floating short-term rates. Vanilla swaps are found in huge numbers, even though there are other swap also related to interest rates, like cases where two floating rates are exchanged against each other.
Usually, financial institutions with very high credit worthiness are the ones that offer the swap market to clients who may be investors or other financial institutions. The financial institution who are the market maker of the swap, execute it in exchange for a fee. The banks try to spread the risk and exposure to interest rate by making the dealers sell the swaps to many parties.
Interest rate swap accounting is often used for speculation and has also been attracting fixed income groups because it shows the expectation of the market regarding interest rates.
We look at Interest Rate Swaps in detail in this article, along with examples -
Learn more about Swaps, valuation, etc. in this detailed Swaps in Finance
Let us look at the different types of such a swap available in the market.
Thus, the above are different types of such kind of swap available in the market.
It is important to understand that the calculation of the payments while doing the interest rate swap valuation for the same will involve the process of evaluation of the net cash flows that each party to the contract will contribute based on the notional amount, the rates that may be either fixed or floating and the current interest rates.
However, the interest rate settlement can be done by either making payment in cash or by taking two swaps of opposite directions and offsetting them. In case of settlement by cash, the amount of net cash flow is calculated, and the required payment is given to the party who is supposed to receive the money. However, in the offsetting process of interest rate swap pricing, the original swap contract is terminated and a completely new contract is made with new terms and conditions.
Let’s see how an interest rate swap works with this basic example.
Let’s say Mr. X owns a $1,000,000 investment that pays him LIBOR + 1% monthly. LIBOR stands for London interbank offered rate and is one of the most used reference rates in the case of floating securities. The payment for Mr. X keeps changing as the LIBOR keeps changing in the market. Now assume there is another guy Mr. Y who owns a $1,000,000 investment that pays him 1.5% every month. His payment never changes as the interest rate assumed in the transaction is fixed in nature.
Now Mr. X decides he doesn’t like this volatility and would rather have fixed interest payments, while Mr. Y explores a floating rate to have a chance of higher payments. This is when both of them enter into an interest rate swap contract. The terms of the contract state that Mr. X agrees to pay Mr. Y LIBOR + 1% every month for the notional principal amount of $1,000,000. Instead of this payment, Mr. Y agrees to pay Mr. X a 1.5% interest rate on the same principal notional amount. Now let us see how the transactions unfold under different scenarios.
Mr. X receives $12,500 from his investment at 1.25% (LIBOR standing at 0.25% and 1%). Mr. Y receives a fixed monthly payment of $15,000 at a 1.5% fixed interest rate. Under the swap agreement, Mr. X owes $12,500 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions partially offset each other. The net transaction would lead Mr. Y to pay $2500 to Mr. X.
Mr. X receives $20,000 from his investment at 2.00% (LIBOR standing at 1.00% and 1%). Mr. Y receives a fixed monthly payment of $15,000 at a 1.5% fixed interest rate. Under the swap agreement, Mr. X owes $20,000 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions partially offset each other. The net transaction would lead Mr. X to pay $5000 to Mr. Y.
So, what did the interest rate swap do to Mr. X and Mr. Y? The swap has allowed Mr. X a guaranteed payment of $15,000 every month. If LIBOR is low, Mr. Y will owe him under the swap. However, if the LIBOR is high, he will owe Mr. Y. Either way, he will have a fixed monthly return of 1.5% during the tenure of the contract. It is very important to understand that under the interest rate swap arrangement, parties entering into the contract never exchange the principal amount. The principal amount is just notional here. There are many uses to which the interest rate swaps are put, and we will discuss each later in the article.
Interest rate swaps are traded over the counter, and generally, the two parties need to agree on two issues when going into the interest rate swap agreement. The two issues under consideration before a trade are the swap's length and the swap's terms. The swap's length will decide the contract's start and termination date of the contract, while the terms of the swap will decide the fixed rate on which the swap will work.
Now that you have understood what a swap transaction is, it is very important to understand what is known as the 'swap rate.' A swap rate is the rate of the fixed leg of the swap as determined in the free market. So, the rate quoted by various banks for this instrument is known as the swap rate. This provides an indication of the market's view, and if the firm believes it can stabilize cash flows by buying a swap or can make a monetary gain doing so, they go for it. So, the swap rate is the fixed interest rate that the receiver demands in exchange for uncertainty, which exists because of the floating leg of the transaction.
The plot of swap rates across all the available maturities is known as the swap curve. It is very similar to the yield curve of any country where the prevailing interest rate across the tenure is plotted on a graph. Since the swap rate is a good gauge of the interest rate perception, market liquidity, and bank credit movement, the swap curve in isolation becomes very important for the interest rate benchmark.
Generally, the sovereign yield curve and swap curve are of similar shape. However, at times there is a difference between the two. The difference between the two is known as 'swap spread.' Historically this difference tended to be positive, which reflected higher credit risk with the banks compared to a sovereign. However, considering other factors indicative of supply-demand liquidity, the U.S. spread currently stands at negative for longer maturities. Please refer to the graph below for a better understanding.
Please refer to the graph below for a better understanding.
The swap curve is a good indicator of the conditions in the fixed income market. It reflects the bank credit situation and the large interest rate view of the market participants. In mature markets, the swap curve has supplanted the treasury curve as the main benchmark to price and trade corporate bonds and loans. It is a primary benchmark in certain situations as it is more market-driven and considers larger market participants.
Big investment firms, along with commercial banks that have strong credit rating history, are the largest swap market makers. They offer fixed and floating rate options to investors who want to go for a swap transaction. The counterparties in a typical swap transaction are generally corporations, banks, or investors on one side and large commercial banks and investment firms on the other. In a general scenario, the moment a bank executes a swap, it usually offsets it through an inter-dealer broker. The bank keeps the fees for initiating the swap in the whole transaction. In cases when the swap transaction is very large, the inter broker-dealer may arrange several other counterparties, spreading the risk of the transaction. This results in a wider dispersion of the risk. This is how banks that hold interest rate risk try to spread the risk to the larger audience. The role of the market makers is to provide ample players and liquidity in the system.
The concept has a number of benefits in the financial market which are used by market participants. Let us learn the same in details.
Like in the case of a non-government fixed income market, an interest rate swap holds two primary risks. These two risks are interest rate risk and credit risk. Credit risk in the market is also known as counterparty risk. The interest rate risk arises because the expectation of the interest rate view might not match the actual interest rate. A Swap also has a counterparty risk, which entails that either party might adhere to contractual terms. The risk quotient for interest rate swaps came to an all-time high in 2008 when the parties refused to honour the commitment of interest rate swaps. It became important to establish a clearing agency to reduce counterparty risk.
Over the years, financial markets have constantly innovated and come up with great financial products. Each of them initiated in the market intending to solve some corporate-related problem and later became a huge market. This has exactly happened with interest rate swap contract or the swap category at large. The objective for the investor is to understand the product and see where it can help them. Understanding the interest rate swap can help an investor gauge an interest rate perception in the market. It can also help an individual decide on when to take a loan and when to delay it for a while. It can also help to understand the kind of portfolio your fund manager is holding and how over the years, they are trying to manage the interest rate risk in the market. Swap is a great tool to manage your debt effectively. It allows the investor to play around with the interest rate and does not limit him to a fixed or floating option.
Both the above concepts are related to derivative contracts where two parties agree to receive cash flow from each other. But there are some differences between them, which are as given below:
Thus, the above are some important differences between the two type of swaps.
Interest rate swaps serve as financial agreements between two parties to exchange future interest payments on a specified notional amount. They allow entities to manage or mitigate interest rate risks by swapping variable interest payments for fixed ones or vice versa. These swaps are crucial in hedging against fluctuating interest rates, reducing exposure to market volatility, and achieving more predictable cash flows.
2. What are the different types of interest rate swaps?Several types of interest rate swaps cater to specific needs. Fixed-for-floating swaps involve exchanging fixed-rate payments for floating-rate payments, often tied to a benchmark like LIBOR. Basis swaps involve exchanging two floating rates, often linked to different currencies. Cross-currency swaps involve swapping interest payments and notional amounts between different currencies. Inflation swaps allow parties to hedge against inflation by exchanging fixed-rate payments for payments linked to an inflation index.
3. What is the difference between a swap and interest rate swap?A "swap" is a broader term encompassing various financial derivatives where two parties exchange cash flows or other financial instruments. An "interest rate swap" is a specific type of swap focused solely on exchanging interest payments. Interest rate swaps involve exchanging fixed or variable interest payments to manage interest rate exposure or optimize cash flow.
Guide to what is Interest Rate Swap. We explain the swap rate, example, types, swap curve, how to calculate, vs currency swap, benefits, risk.
