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Interest Rate Swap

Thursday, January 12, 2012

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Interest rate swaps represent a useful interest risk hedging instrument for more efficient asset and liability management of client’s balance sheets.

An interest rate swap, henceforth abbreviated as an IRS, is a contractual agreement between two parties under which each party agrees to make periodic interest payments to the other for an agreed period of time. The agreement in its most common form states that a series of payments calculated by applying a fixed rate of interest to a notional amount are exchanged for another series of payments calculated at the same notional amount using a floating rate of interest. The fixed rate payment stream is traditionally called the fixed leg, while the floating payments are referred to as the floating leg.

Implications are staggering:

  • Interest rate risk management is CFO´s or Tresurer´s daily business- don’t accept interest rate fluctuations as given and unchallengeable.
  • Separate the decision over the interest rates – fixed or floating – from the borrowing/investment considerations.


Contractual terms of generic interest rate swap

The terms of the particular Transaction to which this Confirmation relates are as follows:

Notional Amount:USD
Fixed Amounts:
Fixed Rate Payer:Bank
Fixed Rate Payer Payment Dates:Semi-annually, on each January 1 and July 1, commencing on July 1, xxxx, and ending on the Termination Date, subject to adjustment in accordance with the Following Business Day Convention.
Fixed Rate:4.75%
Fixed Rate Day Count Fraction:30/360
Fixed Rate Period End Dates:Not Adjusted
Floating Amounts:
Floating Rate Payer:Counterparty
Floating Rate Payer Payment Dates:Semi-annually, on each January 1 and July 1, commencing on July 1, xxxx, and ending on the Termination Date, subject to adjustment in accordance with the Following Business Day Convention.
Floating Rate Option:USD-LIBOR-BBA
Floating Rate Designated Maturity:6 Months
Initial Floating Rate Setting:xxx %
Floating Rate Spread:Plus
Floating Rate Reset Dates:The first day of each Calculation Period
Floating Rate Day Count Fraction:Actual/360
Floating Rate Period End Dates:Adjusted in accordance with the following Business Day Convention.
Business Days:New York and London
Calculation Agent:Bank
Governing Law:New York law


  • Swaps are always quoted in LIBOR terms, giving an equal (corresponding) basis for each of the parties involved in the transactions.
  • The transaction amount is referred to the notional principal amount
  • The swap transaction is totally independent from any underlying borrowing or underlying transaction e.g. a credit or financial investment(i.e. bond).
  • If the swap is quoted against an other index (CP index; treasury), a basis risk will arise.
  • The fee of the bank will be priced in the fixed leg, as LIBOR is a reference rate and therefore beyond changes.
  • Swaps and forward swaps eliminate today’s and/or future’s risks but simultaneously also future chances.
  • In a swap full interest rate payments are not exchanged, but rather the net cash flow (fixed rate - floating rate)

Interest rate swaps:

All convertible currencies, specially USD, EUR, JPY, CHF. Also HUF and PLN possible. Swaps are available for maturities of up to 30 years.

General factors relevant for pricing

  • Current level of interest rates
  • Shape of the yield curve
  • Tenor
  • Rating of counterparties
  • Liquidity of the respective capital markets, possible limitations of capital transfers


in a plain vanilla swap all net cashflows except the first are unknown at the time the swap is entered. A trader or market participant therefore has to form expectations of future Libor rates and use those to price the swap. A swap is just a sequence of forward rate agreements, to be arbitrage free, it is therefore natural to use the Libor futures strip to price swaps. Substituting forward rates as the indices for the future floating cashflows must produce a single fixed rate that equates the NPV of the fixed and floating sides of the swap.



ISDA- International Swap Dealers Association

Unwinding Swap position

An important benefit of using derivatives to hedge interest rate risk is the flexibility of the close-out. Reasons unwind an interest rate hedge transaction may include:

  • No underlying due to pre-payment or restructuring
  • The company changed his opinion about the direction of interest rates and no longer needs the protection.
  • The company wishes to change hedging strategy, by extending or shortening swap tenor.

If the bank enters into an interest rate swap with the corporation, no premium is paid, and the swap starts off with no market value (except, perhaps, that due to a bid-ask spread charged by the dealer). Depending upon fluctuations in interest rates, the swap could take on a positive market value for either the dealer or the corporation. In a payer swap a falling interest rate environment results in a negative mark-to market for the corporation.

Many OTC derivatives are structured with termination features. These provide for the immediate termination of the contract should a specified trigger event occur. Trigger events might include:

  • Failure by a counterparty to perform on the contract or a related contract
  • A downgrade of one of the counterparties' credit ratings
  • A merger or acquisition of one of the counterparties

When a trigger event occurs, the contract is terminated (either automatically or at the option of the other counterparty) and there is an immediate cash settlement between the counterparties for any market value of the contract.

Forward Swap (Variation)

Interest rate swaps are extremely flexible and can be tailored to meet the specific maturity, size and cash flow needs of borrowers. Forward starting swaps, for example, enable floating rate borrowers to continue to benefit from low short-term rates while committing now to pay a fixed rate to begin in the future. The terms and timing of this strategy are entirely flexible with regard to when the forward starting transaction begins and ends.


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