The Terminology of Interest Rate Swaps

Investment risk is often synonymous with the equity markets and stock-price volatility. An acute risk inherent to debt-security investments is fluctuating interest rates. Beginning in 1981 with Eurobonds, interest-rate swaps have evolved from humble beginnings into a mature and integral product in the world of government and corporate finance. Businesses and financial institutions participate in swap transactions to both hedge against and speculate in interest rate volatility.

Plain Vanilla Swaps

Interest-rate swaps are contractual arrangements between two parties who agree to exchange interest payments for a fixed period of time, based on a defined principal amount, without transferring the underlying securities. The plain vanilla swap is the most popular form in which one party agrees to pay the other party a fixed sum on a recurring basis in exchange for receiving a variable-rate, or floating, payment.

Counterparties

Participants in interest-rate swaps are referred to as counterparties. In a fixed-for-floating rate swap, the fixed-rate payer is considered the seller of the swap and the floating-rate payer, the buyer. Both counterparties are wagering that interest rates will move in opposite directions. The swap seller realizes a profit if interest rates rise while the swap buyer profits if interest rates fall. Parties engage in swap contracts to lower financing costs in terms of the "spread" between the net proceeds from the swap and their debt-service obligations on loans or bonds issued.

Swap and Reference Rate

Plain vanilla swaps essentially transform an underlying fixed interest rate into a floating rate obligation. The fixed interest rate, referred to as the swap rate, is determined at the beginning of the transaction. However, the floating interest rate is pegged to a reference rate, such as LIBOR (London Interbank Offer Rate), which can periodically be adjusted higher or lower on each reset date.

Notional Amount

The notional amount, or principal, forms the base upon which interest payments are computed. For example, a notional amount $10 million with a swap rate of five percent and a LIBOR rate of four percent will yield reciprocal annual payments of $500,000 and $400,000 respectively, exchanged between counterparties. Moreover, the notional amount may be arbitrary without any underlying tangible collateral.

Gross and Net Swaps

Interest-rate swaps can take the form of either gross or net transactions. In a gross transaction, the full interest payments are exchanged between counterparties. However, in a net transaction, only the difference in monetary value actually changes hands.

ISDA Master Agreement

The International Swaps and Derivatives Association is the governing body for interest-rate swaps. The ISDA Master Agreement is multi-currency, cross-border, industry-standard document that covers the specific terms and conditions for derivative transactions and serves as the framework for counterparties entering into interest-rate swap contracts.

References

• Southern Finance Association Meeting, San Antonio, 1988, R. Daigler & D. Steelman: Interest Rate Swaps and Financial Institutions
• International Swaps and Derivatives Association, Inc.: Interest Rate Swap Example
• New York University, Leonard N. Stern School of Business: Interest Rate Swaps
• CIT Capital Markets: Interest Rate Swaps
• California Debt and Investment Advisory Commission: Fundamentals of Interest Rate Swaps

Resources

• International Swaps and Derivatives Association: