|Definition||Over-the-counter (OTC) contract that allows the exchange of fixed-rate interest flows for floating-rate interest flows on the basis of a nominal amount|
|Underlying risk||Interest rate|
|Cash / Derivative||Derivative|
|Market||OTC: Over The Counter|
The key characteristics of a swap are listed below - at least the most common ones, for a "plain vanilla" swap. But since swaps are Over The Counter contracts, everything is negotiable.
|Nominal amount||Amount of the swap, which is used to compute interest. This amount is notional, that is to say it is not exchanged.|
|Value date||Date from which interest is calculated|
|Maturity date||Interest Rate Swap contracts may have a duration from 2 years to 20 years and more|
|Fixed leg||Variable leg|
|Direction: lending or borrowing||Direction: borrowing or lending|
Floating rate market reference: rate of the variable leg. This is a reference rate of the market, often the LIBOR (London Interbank Offered Rate), which will be used to calculate the payments of the variable leg.
Spread: margin applied to the reference rate of the variable leg
|Frequency: interval between two payments (1 year, 6 months, 3 months)||Frequency: interval between two payments (3 months or 6 months)|
|Method used for the calculation of interest||Method used for the calculation of interest|
Assuming A and B are the two parties involved in an interest rate swap (IRS), A and B actually simulate two simultaneous operations:
- The one where A lends to B the nominal amount of the swap at a fixed rate, payable according to a schedule defined during the negotiation.
- The other where B lends to A the nominal amount of the swap at a floating rate indexed to a market rate, here also with a frequency defined during the negotiation.
The exchange of the nominal amount does not occur. At each intermediate due date (fixed or variable), the two parties simply pay or receive interest payments calculated according to the direction of the contract:
- The fixed rate lender A, borrowing at a variable rate, pays B at a rate calculated on each due date, based on a reference rate chosen during the negotiation of the contract (for example 3 month LIBOR).
- The variable rate lender B, borrowing at a fixed rate, pays A at a fixed rate on a frequency defined in advance.
Concretely, since the principal amount is not exchanged, a swap contract amounts to exchanging a stream of interest against another.
This kind of operation allows to hedge against
interest rate risk. For example a company anticipating an interest rate cut can transform a fixed-rate debt into a floating-rate debt: it just has to find a counterparty (usually a bank) agreeing to pay the fixed rate in exchange for the floating rate. Since the company also pays a fixed rate to its creditor, then everything goes as if it had borrowed at a variable rate.
It is important to understand that both parties involved in the swap may have interest in the contract and benefit from it. This will depend on their respective markets, and their bargaining power in this market. In the previous example, the bank that has agreed to pay the fixed rate will find it easier than its customer to refinance its position on the interbank market. The idea is to get the type of desired rate from the party that can more easily obtain it given its position in its own market.
Interest rate swaps are also speculative instruments that allow traders to take positions on the maturity dates of the yield curve based on their expectations about its evolution.
At the initiation of the contract, there is simply an exchange of confirmations. Afterwards:
- each due date of the fixed leg triggers an interest payment
- each due date of the variable leg triggers:
- an interest payment for the elapsed period
- the determination of the new rate for the coming period (fixing). If necessary, both parties may exchange a new confirmation to ensure that the observed rate is the same on both sides.
The nominal amount of the swap does not change hands, which is why we talk about a "notional" amount. Only interest flows are exchanged on the dates specified in the contract. Both parties may agree to exchange only the net sum of the amounts due from both sides (netting agreement).
An interest rate swap is valued in relation with the market rates ("marked to market"). The value of the swap for each party is equal to the difference between the discounted value of the flows to be received and the discounted value of the flows to be paid. The yield curve used for the calculation is obtained from the yield curve of government securities, plus a "spread" related to the variable rate payer, that is to say, the risk premium that the fixed rate payer will require based on the rating of the other party.
At the initiation of the operation, the characteristics are usually calculated in such a way that the contract value is zero for both parties. Afterwards the party for whom the value is positive is "winning" on the contract. It is also at risk since the other party owes more money! This consideration is important for collateral management.
Swaps are traded exclusively over the counter. Before starting negotiations, the parties usually first sign a legal agreement, or "master agreement" that sets the legal framework and general rules that will apply afterwards to all transactions. The most commonly used legal agreement is the one proposed by the ISDA (International Swaps and Derivatives Association)
After signing the legal agreement, the exchanged confirmations only present the characteristics of the specific transaction (nominal, duration, rate, etc.) and refer to the legal agreement for all specific situations that may occur during the lifetime of the transaction.
As transactions are negotiated bilaterally, they can be adapted at will as both parties decide, which results in a high variability of the transactions put in place.
Because swaps are traded over the counter, for a long time there was no clearing house or any kind of intermediary, resulting in a significant counterparty risk. This explains why transactions are very often collaterised.
Today a compensation offer is growing, with actors such as LCH Clearnet in Europe, ICE Trust and CME Clearing in the U.S. Knowing that actors such as Tradeweb also position themselves on negotiation, others on transaction matching, the market tends to be more and more organised, at least regarding "vanilla" swaps.
Cross currency swap: Interest rate swap in which both legs are denominated in different currencies. Unlike the single currency swap, the notional amounts of the two legs can be exchanged at the beginning and at the end of the contract. This instrument, however, remains mainly an interest rate derivative, unlike the foreign exchange swap (FX swap), which is a currency derivative.
OIS (Overnight Indexed Swap): Interest rate swap in which the variable leg is indexed to an overnight rate (EONIA for the Euro) and accrued interest is capitalized on the variable leg. This type of contract usually has a much shorter duration than "classic" interest rate swaps (less than a year).
Swaption or swap option: As its name suggests it is an option, that is to say a contract giving the buyer, upon the payment of a premium, the right, but not the obligation, to set up a swap with the seller having the characteristics defined during the negotiation of the option, during a reference period (American option) or at the end of this period (European option).