Interest rate swap

An interest rate swap (IRS) is a liquid nancial derivative instrument in which two parties agree to exchange
interest rate cash ows, based on a specied notional
amount from a xed rate to a oating rate (or vice versa)
or from one oating rate to another.[1] Interest rate swaps
can be used for both hedging and speculating.

B pays oating rate to A (B receives xed rate)

Currently, A borrows from Market @ LIBOR +1.5%. B
borrows from Market @ 8.5%.
Consider the following swap in which Party A agrees
to pay Party B periodic xed interest rate payments of
8.65% in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%) in the same currency. 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 interest
payments are settled in net; that is, Party A pays (LIBOR
+ 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net. The
xed rate (8.65% in this example) is referred to as the
swap rate.[2]

Structure

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 50bps over LIBOR to compensate
for this.

2 Types

Party A is currently paying oating rate, but wants to pay xed

rate. Party B is currently paying xed rate, but wants to pay oating rate. By entering into an interest rate swap, the net result is
that each party can swap their existing obligation for their desired
obligation.

In an interest rate swap, each counterparty agrees to pay

either a xed or oating rate denominated in a particular
currency to the other counterparty. The xed or oating
rate is multiplied by a notional principal amount (say, $1
million) and an accrual factor given by the appropriate
day count convention. When both legs are in the same
currency, this notional amount is typically not exchanged
between counterparties, but is used only for calculating
the size of cashows to be exchanged. When the legs are
in dierent currencies, the respective notional amounts
are typically exchanged at the start and the end of the
swap, which is called cross currency interest rate swap.

Normally the parties do not swap payments directly, but rather

each sets up a separate swap with a nancial intermediary such
as a bank. In return for matching the two parties together, the
bank takes a spread from the swap payments (in this case 0.30%
compared to the above example)

As OTC instruments, interest rate swaps can come in a

number of varieties and can be structured to meet the
specic needs of the counterparties. For example, the
legs of the swap could be in same or dierent currencies;
the notional of the swap could be amortized over time;
reset dates (or xing dates) of the oating rate could be
irregular.

The most common interest rate swap involves counterparty A paying a xed rate (the swap rate) to counterparty
B while receiving a oating rate indexed to a reference
rate like LIBOR, EURIBOR, or MIBOR. By market
convention, the counterparty paying the xed rate is the
payer (while receiving the oating rate), and the counterparty receiving the xed rate is the receiver (while
paying the oating rate).

The interbank market, however, only has a few standardized types which are listed below. Each currency has

A pays xed rate to B (A receives oating rate)

1

TYPES

its own standard market conventions regarding the fre- receive JPY LIBOR + 35bps. With this, they have efquency of payments, the day count conventions and the fectively locked in a 35bps prot instead of running with
end-of-month rule.[3]
a current 40bps gain and index risk. The 5bps dierence (w.r.t. the current rate dierence) comes from the
swap cost which includes the market expectations of the
2.1 Fixed-for-oating rate swap, dierent future rate dierence between these two indices and the
currencies
bid-oer spread, which is the swap commission for the
dealer.
For example, if a company has a $10 million xed rate
Floating-for-oating rate swaps are also seen where both
loan at 5.3% paid monthly and a oating rate investment
sides reference the same index, but on dierent payment
of JPY 1.2 billion that returns JPY 1M Libor +50bps evdates, or use dierent business day conventions. This
ery month, and wants to lock in the prot in USD as they
can be vital for asset-liability management. An example
expect the JPY 1M Libor to go down or USDJPY to go up
would be swapping 3M LIBOR being paid with prior non(JPY depreciate against USD), then they may enter into a
business day convention, quarterly on JAJO (i.e., Jan,
xed-for-oating swap in dierent currencies where the
Apr, Jul, Oct) 30, into FMAN (i.e., Feb, May, Aug, Nov)
company pays oating JPY 1M Libor+50bps and receives
28 modied following.
5.6% xed rate, locking in 30bps prot against the interest rate and the FX exposure.

2.2
2.3
2.4

2.7 Fixed-for-xed rate swap, dierent

currencies
Floating-for-xed rate swap, same currency
Party P pays/receives xed interest in currency A to reFixed-for-oating rate swap, same cur- ceive/pay xed rate in currency B for a term of T years.
For example, you pay JPY 1.6% on a JPY notional of
rencies
1.2 billion and receive USD 5.36% on the USD equivalent notional of $10 million at an initial exchange rate of
Floating-for-xed rate swap, dierent USDJPY 120.

currencies

2.5

Fixed-for-xed rate swap, same cur- 2.8 Floating-for-oating rate swap, dierrency
ent currencies

2.6

Floating-for-oating rate swap, same Party P pays/receives oating interest in currency A indexed to X to receive/pay oating rate in currency B incurrency

dexed to Y on a notional N at an initial exchange rate of

FX for a tenure of T years. The notional is usually exchanged at the start and at the end of the swap. This is
the most liquid type of swap with dierent currencies.
For example, you pay oating USD 3M LIBOR on the
USD notional 10 million quarterly to receive JPY 3M TIBOR quarterly on a JPY notional 1.2 billion (at an initial
exchange rate of USDJPY 120) for 4 years; at the start
you receive the notional in USD and pay the notional in
JPY and at the end you pay back the same USD notional
(10 million) and receive back the same JPY notional (1.2
Floating-for-oating rate swaps are used to hedge against billion).
or speculate on the spread between the two indexes. For For example, consider a U.S. company operating in Japan
example, if a company has a oating rate loan at JPY 1M that needs JPY 10 billion to fund its Japanese growth. The
LIBOR and the company has an investment that returns easiest way to do this is to issue debt in Japan, but this
JPY 1M TIBOR + 30bps and currently the JPY 1M TI- may be expensive if the company is new in the Japanese
BOR = JPY 1M LIBOR + 10bps. At the moment, this market and lacking a good reputation among the Japanese
company has a net prot of 40bps. If the company thinks investors. Additionally, the company may not have the
JPY 1M TIBOR is going to come down (relative to the appropriate debt issuance program in Japan or may lack
LIBOR) or JPY 1M LIBOR is going to increase in the a sophisticated treasury operation in Japan. The company
future (relative to the TIBOR) and wants to insulate from could issue USD debt and convert to JPY on the FX marthis risk, they can enter into a oat-oat swap in same ket. This option solves the rst problem, but it introduces
currency where they pay, say, JPY TIBOR + 30bps and two new risks:
Party P pays/receives oating interest in currency A indexed to X to receive/pay oating rate in currency A indexed to Y on a notional N for a tenure of T years. For
example, you pay JPY 1M LIBOR monthly to receive
JPY 1M TIBOR monthly on a notional JPY 1 billion for
three years or you pay EUR 3M EURIBOR quarterly to
receive EUR 6M EURIBOR semi-annually. The second
example, where the indexes are the same type but with
dierent tenors, are the most liquid and most commonly
traded same currency oating-for-oating swaps..

3.2

British local authorities

FX risk: If this USDJPY spot goes up at the matu- The interest rate swap market in USD is closely linked to
rity of the debt, then when the company converts the the Eurodollar futures market which trades among others
JPY to USD to pay back its matured debt, it receives at the Chicago Mercantile Exchange.
less USD and suers a loss.
USDJPY interest rate risk: If JPY rates come
down, the return on the investment in Japan may also 3.2 British local authorities
go down, introducing interest rate risk.
In June 1988 the Audit Commission was tipped o by
The FX risk can be hedged with long-dated FX forward someone working on the swaps desk of Goldman Sachs
contracts, but this introduces yet another risk where the that the London Borough of Hammersmith and Fulham
implied rate from the FX spot and the FX forward is a had a massive exposure to interest rate swaps. When the
xed but the JPY investment returns a oating rate. Al- commission contacted the council, the chief executive
though there are several alternatives to hedge both expo- told them not to worry as everybody knows that interest
sures eectively without introducing new risks, the easi- rates are going to fall"; the treasurer thought the interest
est and most cost-eective alternative is to use a oating- rate swaps were a nice little earner. The Commissions
Controller, Howard Davies, realised that the council had
for-oating swap in dierent currencies.
put all of its positions on interest rates going down and
ordered an investigation.

2.9

Other variations

A number of other far less common variations are possible. Mostly tweaks are made to ensure that a bond is
hedged perfectly, so that all the interest payments received are exactly oset, which can lead to swaps where
the principal is paid on one or more legs, rather than just
interest (for example to hedge a coupon strip), or where
the balance of the swap is automatically adjusted to match
that of a prepaying bond like residential mortgage-backed
securities.
Brazilian Swap

By January 1989 the Commission obtained legal opinions from two Queens Counsel. Although they did not
agree, the commission preferred the opinion which made
it ultra vires for councils to engage in interest rate swaps.
Moreover, interest rates had increased from 8% to 15%.
The auditor and the commission then went to court and
had the contracts declared illegal (appeals all the way up
to the House of Lords failed in Hazell v Hammersmith
and Fulham LBC); the ve banks involved lost millions of
pounds. Many other local authorities had been engaging
in interest rate swaps in the 1980s.[4] This resulted in several cases in which the banks generally lost their claims
for compound interest on debts to councils, nalised in
Westdeutsche Landesbank Girozentrale v Islington London Borough Council.[5]

Uses

Interest rate swaps are used to hedge against or speculate

on changes in interest rates.

4 Valuation and pricing

Further information: Rational_pricing Swaps

3.1

Speculation

The valuation of vanilla swaps was often done using the

so-called textbook formulas using a unique curve in each
currency. Some early literature described some incoherence introduced by that approach and multiple banks
were using dierent techniques to reduce them. It became even more apparent with the 20072012 global
nancial crisis that the approach was not appropriate.
The now-standard pricing framework is the multi-curves
framework.

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, xed 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 oating-for-xed interest rate swap; as rates fall, investors would pay a lower oating rate in exchange for the
The present value of a plain vanilla (i.e., xed rate for
same xed rate.
Interest rate swaps are also popular for the arbitrage oating rate) swap can be computed by determining the
opportunities they provide.
Varying levels of present value (PV) of the xed leg and the oating leg.

creditworthiness means that there is often a posi- The value of the xed leg is given by the present value of
tive quality spread dierential that allows both parties to the xed coupon payments known at the start of the swap,
benet from an interest rate swap.
i.e.

P Vxed = N C

n (

)
i P D (ti )

RISKS

Therefore, at the time the contract is entered into, there

is no advantage to either party, i.e.,

i=1

P Vxed = P Voat
where C is the swap rate, n is the number of xed payments, N is the notional amount, i is the accrual factor Thus, the swap requires no upfront payment from either
according to the day count convention for the xed rate party.
period and P D (ti ) is the discount factor for the payment
During the life of the swap the same valuation technique
time ti .
is used, but since, over time, both the discounting factors
The value of the oating leg is given by the present value and the forward rates change, the PV of the swap will
of the oating coupon payments determined at the agreed deviate from its initial value. Therefore, the swap will
dates of each payment. However, at the start of the swap, be an asset to one party and a liability to the other. The
only the actual payment rates of the xed leg are known in way these changes in value are reported is the subject of
the future, whereas the forward rates are unknown. The IAS 39 for jurisdictions following IFRS, and FAS 133 for
forward rate for each oating payment date is calculated U.S. GAAP. Swaps are marked to market by debt security
using the forward curves. The forward rate for the period traders to visualize their inventory at a certain time.
[tj1 , tj ] with accrual factor i is given by

Fj =

1
j

)
P I (tj1 )

1
P I (tj )

5 Risks

Interest rate swaps expose users to interest rate risk and

where I is the market index, such as USD LIBOR, and credit risk.
P I (tj ) is the discount factor associated to the relevant
forward curve. The value of the oating leg is given by
Market risk: A typical swap consists of two legs
the following:
one xed, the other oating. The risks of these
two component will naturally dier. Newcomers to
market nance may think that the risky component
m

is the oating leg, since the underlying interest rate

P Voat = N
(Fj j P D (tj ))
oats, and hence, is unknown. This rst impression
j=1
is wrong. The risky component is in fact the xed
leg and it is very easy to see why this is so.[7]
where m is the number of oating payments, i is the accrual factor according to the oating leg day count con(Comment: the above comment is not entirely accurate.
vention.
Normally people will assume a hypothetical notional exIn the event that
change at the end. After this hypothetical assumption, the
PD = PI ,
swap can be understood as a oating rate bond vs a xed
rate bond. The risks on the oating bond side are small
this formula simplies to
compared to the risks from the xed rate bond side. HowP Voat = N (1 P D (tm ))
ever, without this hypothetical notional exchange at the
on the reset dates, since the summation in P Voat tele- end, purely the oating cash ow from the coupon payscopes to the rst and last terms only. On reset dates, the ments will have higher risks than the cash ow from the
xed coupon payments. Both understanding have their
value of an o-the-run swap (old issue) is given by
merit and fully understand these two views are important
P Vxed P Voat = N (Beq 1)
to see the risks, particularly for oating oating swaps)
where Beq is the value of hypothetical bond that mimics The discussion of pricing interest rate swaps illustrated
the xed leg of the swap with a unit principal payable at an important point. Regardless of what happens to fuexpiry. On none reset dates the swap value becomes
ture Libor rates, the value of a rolling deposit or oating
P Vxed P Voat = N (Beq P D (tr ))

rate note (FRN) always equals the notional amount N at

the reset dates. Between the reset dates this value may
where tr is the nearest reset date. The xed rate oered in
be dierent from N, but the discrepancy cannot be very
the swap is the rate which values the xed rates payments
large since the will be 3 or 6 months. Interest rate ucat the same PV as the variable rate payments using todays
tuations have minimal eect on the values of xed inforward rates, i.e.:
struments with short maturities; in other words, the value
of the oating leg changes very little during the life of a
C = n (NPVoatP D (t )) [6]
swap.
i
i
i=1

5
On the other hand, the xed leg of a swap is equivalent to
a coupon bond and uctuations of the swap rate may have
major eects on the value of the future xed payments.
Credit risk on the swap comes into play if the swap
is in the money or not. If one of the parties is in
the money, then that party faces credit risk of possible default by another party. However, when the
swap is negotiated through an intermediary nancial institution, usually the intermediary assumes the
default risk in exchange for a xed percentage of
the transaction (the bid-ask spread). In an intermediated swap, the two parties are not typically even
aware of the identity of the second party to the transaction, making a quantication of the other partys
credit risk not only irrelevant, but impossible.

Market size

On its December 2014 statistics release, the Bank for International Settlements reported that interest rate swaps
were the largest component of the global OTC derivative
market representing 60% of it, with the notional amount
outstanding in OTC interest rate swaps of $381 trillion,
and the gross market value of $14 trillion.[8]
Interest rate swaps can be traded as an index through the
FTSE MTIRS Index.

See also
Swap rate

[4] Duncan Campbell-Smith, Follow the Money: The Audit Commission, Public Money, and the Management of
Public Services 1983-2008, Allen Lane, 2008, chapter 6
passim.
[5] [1996] UKHL 12, [1996] AC 669
[6] Understanding interest rate swap math & pricing (PDF).
California Debt and Investment Advisory Commission.
January 2007. Retrieved 2007-09-27.
[7] http://chicagofed.org/webpages/publications/
understanding_derivatives/index.cfm
[8] OTC derivatives statistics at end-December 2014
(PDF). Bank for International Settlements.

Pricing and Hedging Swaps, Miron P. & Swannell

P., Euromoney books 1991
Early literature on the incoherence of the one curve pricing approach.
Interest rate parity, money market basis swaps and
cross-currency basis swaps, Tuckman B. and Porrio P., Fixed income liquid markets research,
Lehman Brothers, 2003.
Cross currency swap valuation, Boenkost W. and
Schmidt W., Working Paper 2, HfB - Business
School of Finance & Management, 2004. SSRN
preprint.
The Irony in the Derivatives Discounting, Henrard
M., Wilmott Magazine, pp. 9298, July 2007.
SSRN preprint.
Multi-curves framework:

Interest rate cap and oor

Equity swap
Total return swap
Ination derivative
Eurodollar
Constant maturity swap
FTSE MTIRS Index

References

[1] Interest Rate Swap. Glossary. ISDA.

A multi-quality model of interest rates, Kijima M.,

Tanaka K., and Wong T., Quantitative Finance,
pages 133-145, 2009.
Two Curves, One Price: Pricing & Hedging Interest
Rate Derivatives Decoupling Forwarding and Discounting Yield Curves, Bianchetti M., Risk Magazine, August 2010. SSRN preprint.
The Irony in the Derivatives Discounting Part II: The
Crisis, Henrard M., Wilmott Journal, Vol. 2, pp.
301316, 2010. SSRN preprint.

9 External links

[2] "Interest Rate Swap" by Fiona Maclachlan, The Wolfram

Demonstrations Project.

Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial
Markets Group

[3] "Interest Rate Instruments and Market Conventions

Guide" Quantitative Research, OpenGamma, 2012.

Bank for International Settlements - Semiannual

OTC derivatives statistics

9
Glossary - Interest rate swap glossary
Investopedia - Spreadlock - An interest rate swap future (not an option)
Basic Fixed Income Derivative Hedging - Article on
Financial-edu.com.
Hussman Funds - Freight Trains and Steep Curves
Interest Rate Swap Calculator
Historical LIBOR Swaps data
All about money rates in the world: Real estate interest rates, WorldwideInterestRates.com

EXTERNAL LINKS

10
10.1

Text and image sources, contributors, and licenses

Text

Interest rate swap Source: https://en.wikipedia.org/wiki/Interest_rate_swap?oldid=710329676 Contributors: SimonP, Maury Markowitz,

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10.3

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