Interest Rate Swap | Examples | Uses | Swap Curve

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.

• An interest rate swap involves exchanging interest payments between two parties based on fixed and floating rates.
• Interest rate swap agreements require terms setting, including fixed rates and contract dates, and are traded over the counter.
• The swap curve illustrates swap rates across maturities, similar to a nation's yield curve. It is essential for interest rate benchmarks, reflecting market liquidity, credit trends, and interest rate perceptions.
• Interest rate swaps are risk management tools, allowing parties to hedge against interest rate fluctuations and achieve desired cash flow structures.

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.

• Fixed to floating – In this case an institution, that we assume as Bank A, may enter into a contract to exchange its fixed rate payment with that of floating rate from another bank or financial institution, which we assume as Bank B, because Bank A feels that it can generate cash flows from the floating rates. So, in this case, B will pay floating rates to A, through a contract which will have the same maturity date and cash flow of the loan that Bank A took against fixed rate interest payment. The floating rate index used in this case will be the LIBOR.
• Floating to fixed – In this case, quite different from the above, the rate takers are typically those who do not have access to fixed rate borrowings. They borrow at floating rate and then enter into a swap agreement to get fixed rate. The payment dates are netted against each other. The fixed rate part becomes the rate at which the company has borrowed.
• Float to float – In this case the companies enter into a contract to swap the time period or the type of the index. This is also called basis swap. Here they can swap from a three-month to a six-month LIBOR. They may do it because of better rates or rates match with their payment flows.

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.

Scenario 1: LIBOR standing at 0.25%

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.

Scenario 2: LIBOR standing at 1.00%

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.

• One of the uses of interest rate swap pricing to which interest rate swaps are put is hedging. In case an organization is of the view that the interest rate would increase in the coming times, and there is a loan against which they are paying interest. Let us assume that this loan is linked to 3 monthly LIBOR rates. If the organization believes that the LIBOR rate will shoot up in the coming times, the organization can then hedge the cash flow by opting for fixed interest rates using an interest rate swap. This will provide some certainty to the cash flow of the organization.
• The banks use interest rate swaps to manage interest rate risk. They tend to distribute their interest rate risk by creating smaller swaps and distributing them in the market through an inter-dealer broker. We will discuss this attribute and transaction in detail when we look at who are the market makers in the business.
• A huge tool for fixed-income investors. They use it for speculation and market creation. Initially, it was only for corporations, but as the market grew, people started perceiving the market as a way to gauge interest rate views held by the market participants. This was when many fixed-income players started actively participating in the market.
• The interest rate swap works as an amazing portfolio management tool. It helps in adjusting the risk related to interest rate volatility. In the case of fund managers who want to work on a long-duration strategy, the long-dated interest rate swaps help increase the portfolio's overall duration.

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.

source: Bloomberg.com

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.

source: Bloomberg.com

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.

• Flexible – Since these contracts can be customized to meet the requirements of the parties, the terms and condition can be changed to generate cash flows and can be used for speculation and hedging.
• Manage risk – This form of derivative is an important and effective method to manage and mitigate risk involved in interest rates. The risk mainly arises from volatility in interest rates, which affect the debts taken by borrowers. This tool helps to lock the rates and control their expose to this volatility.
• Cost control – This also helps to control the cost of borrowing and increase the return on investments. For instance, the fixed for floating swap help borrowers use the advantages of lower floating rates which the lender can take advantage of the higher fixed rate.

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:

• The most significant difference between them is that, as per the name itself suggests, the interest rate swap accounting deals with exchange of interest rates, while the latter deals with exchange of money by between two currencies.

• The former involves changing the rates from fixed to floating or vice versa. But in case of the latter, the cash flows generated from two separate currencies are exchanged.

• For the former, it is used against interest rate fluctuation and take advantage of this volatility and gain cash flow, but the latter is used as a hedge against volatility of exchange rates.

• The interest rate swap contract is a financial derivative while the latter is a derivative related to foreign exchange.

• The former is often used for speculation by fixed income groups because it shows the market expectations about interest rate, and the latter is used for improving the lending rates and get foreign exchange.

Thus, the above are some important differences between the two type of swaps.

Guide to what is Interest Rate Swap. We explain the swap rate, example, types, swap curve, how to calculate, vs currency swap, benefits, risk.

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