Introduction
An interest rate swap in its most basic form, often called a plain vanilla swap, is a financial contract in which two parties agree to simultaneously lend from, and borrow to, each other a certain amount of money in the same currency for the same duration but using different interest rates, generally a fixed rate and a floating rate. The nominal amount for each of these two parts to the swap, called legs, are not exchanged in that basic form as this would result in both parties paying and receiving an identical amount of money at the start and the end of the swap. The only cash flows which actually take place during the normal life of a vanilla swap are interest payments which are due periodically. If the interest payments on both legs occur at the same dates, they are often netted. That means that both due payments are compared and only the difference is paid by the party which owes the higher amount.
At swap initiation, the fixed rate is typically chosen in such a way as to make the present value of cash flows equal between the two counterparties. This fixed rate is referred to as the swap rate.
Characteristics of interest rate swaps
Interest rate swaps being financial over-the-counter instruments, the characteristics for each contract are subject to negotiation between the two counterparties.
Nominal or principal amount
This is the amount on which the interest is calculated. This amount generally remains the same over the entire lifetime of the swap, with the exceptions of amortizing or accreting swaps, which are described below. The majority of types of interest rate swaps are single currency, which means that there is only one nominal amount and thus there is no exchange of nominal between the two counterparties as the payments would cancel each other out. In the case of currency swaps, however, where there are two nominals, one for each leg, in different currencies, exchange of nominals usually takes place at the beginning and the end of the swap.
Interest rates
Fixed rate
The fixed rate is negotiated at the conclusion of the swap trade, and depends on market conditions at the time of the transaction and potentially the characteristics of an underlying to be hedged. The counterparties agree on the rate itself, as well as the day-count convention to be applied.
Floating rate
A floating rate is an interest rate which is calculated using a reference interest rate, like for example a LIBOR or EURIBOR.
Duration
The lifetime of the swap. It can go from as short as one week to as long as 30 years or more.
Schedule
The scheduling of all of the events that occur during the life of the swap are determined at the moment the swap transaction is concluded: start date, maturity date, periodicity of payments for each leg, fixing dates for the variable interest rate.
Sometimes, a swap can have a long or short first and/or last payment period, called a stub. This can happen when one of the counterparties needs to align the payment dates with those of another transaction. A frequent example is that of an asset swap, where one of the swap legs needs to match the payments generated by the asset.
Currency
The currency in which the swap is denominated and in which payments are made. As mentionned before, most interest rate swap types are single currency, but there are also types of interest rate swaps which are using more than one currency, like currency swaps or quanto swaps.
Master agreement
Master agreements are contracts that are signed between two counterparties who frequently do over-the-counter derivatives trades with each other and sets out standard terms that apply to each transaction entered into between those two entities. The most commonly used master agreement is the ISDA master agreement, published by the International Swaps and Derivatives Association (ISDA). The advantage of signing a master agreement is that the terms agreed upon in that document do not need to be renegotiated for each individual transaction and apply automatically.
Cost of a swap transaction
Entering into a swap itself does not generate any particular cost, with the exception of fees due to brokers or electronic trading platforms, or the administrative cost of handling the confirmations, payments etc.
Cancellation of a swap
In case one of the counterparties would like to get out of the swap transaction before its maturity, both parties can reach a mutual consent to terminate the swap early. The party seeking termination has to pay the other party a lump-sum amount equal to the net present value of the swap at the time of termination. The amount to be paid depends on how interest rates and spreads have evolved since the conclusion of the swap.
Typology of interest swaps
The basic plain vanilla swap described in the introduction is still the most common form of swaps, but with time many more forms of interest rate swaps have developed. Those most frequently encountered are briefly described below.
Basis swap
A basis swap is a variation of the standard interest rate swap with the particularity that the two interest rate flows which are exchanged are both variable rates, indexed on two different interest rate indexes. An example would be a 3-month LIBOR against a 6-month LIBOR.
Indexes in a basis swap may have different payment frequencies, as in a 3-month LIBOR for 6-month LIBOR swap. One solution is to have respective sides of the swap make payments according to their own schedules. The 3-month LIBOR side would make quarterly payments and the 6-month LIBOR side would make half-yearly payments. Another alternative is to accumulate the more frequent payments with compound interest. In this case, 3-month LIBOR payments would be accumulated and paid half-yearly to match the half-yearly payments of the 6-month LIBOR side.
Basis swaps are quoted with a spread over one of the two indexes with the other index being paid "flat".
A basis swap is used for example when a bank pays interest indexed on one rate but refinances itself on a different rate and wants to protect itself against the risk of the spread between the two indexes moving in an unfavorable direction.
Currency swap
Also called cross currency swap, this type of swap is an interest rate swap where both legs are denominated in different currencies. In most cases, currency swaps are traded with an exchange of nominal at both the start and the end of the swaps lifetime. Also, cash flows occurring during the lifetime of the swap cannot be netted, as they are denominated in different currencies. Currency swaps can be used for example to convert a loan in one currency into a loan in a different currency where better conditions can be obtained.
Forward swap
A forward swap agreement, also referred to as a “forward start swap”, “delayed start swap”, and a “deferred start swap”. It can be created through the combination of two swaps with different durations and opposite interest rate references.
Forward swaps can provide the solution for a bank or corporation that needs protection against interest rate risk for a three-year duration beginning one year from now. By entering into both a one-year and four-year swap, it would create the forward swap that meets its needs.
Amortizing swap
An amortizing swap is a swap in which the principal amount decreases with time. Typically, amortizing swaps are entered into when hedging an underlying financial instrument or transaction which itself has a declining principal, such as a mortgage.
The decrease in the principal amount can be either regular or irregular. A bank or investor will, for example, enter into an amortizing swap with irregular amortization when the swap is concluded as a hedge for a portfolio of mortgage loans where the mortgage borrowers have the possibility of early redemption. The principal of the swap is then adjusted as soon as the actual remaining amount to be hedged is known.
Accreting principal swap
An accreting principal swap is a swap in which the principal amount increases over the life of the swap. It is thus the opposite of an amortizing swap.
Other names of an accreting principal swap are accreting swap, accumulation swap, drawdown swap, and step-up swap.
Zero-coupon swap
In its most common form, a zero-coupon swap is a swap in which floating interest-rate payments are made periodically, but fixed-rate payments are made as one lump-sum payment when the swap reaches maturity. The amount of the fixed-rate payment is based on the swap's zero coupon rate. It is also possible for the floating-rate payments to be paid as a lump sum.
Alternative forms of zero coupon swaps also exist. Thus, a reverse zero-coupon swap will pay the lump-sum payment at the start of the swap rather than at the end, which reduces credit risk for the party paying the floating rate.
An exchangeable zero-coupon swap contains an embedded option to turn the lump-sum payment into a series of payments.
Asset swap
An asset swap is an interest rate swap which is used to transform cash flows generated by an asset. Therefore, the real particularity of an asset swap is that the interest rate payments of one of its legs match exactly the cash flows the asset generates, but in the opposite direction. Apart from that, any type of transformation described in the previous types of swaps may be made, i.e. fixed to floating, floating to fixed, floating to floating, one currency to another, etc. The most frequent case, however, is the transformation from fixed rate to floating rate or vice versa.
Quanto swap
Sometimes also called differential swap, a quanto swap is a swap in which interest on both legs is paid in the same currency, called the reference currency, but calculated on interest rate indexes in two different currencies. Examples would be for example a swap where one counterparty would pay 3-month USD LIBOR and receive 3-month EURIBOR with both legs settled in US Dollars. This variant is called a floating-for-floating quanto swap.
A different form of quanto swap is the fixed-for-floating quanto swaps. An example of this would be a swap where one counterparty would pay a fixed rate and receive 3-month EURIBOR with both legs settled in US Dollars.
Constant Maturity Swap (CMS)
A constant maturity swap is an interest rate swap where the interest rate on one leg is reset periodically, but with reference to a long-term market swap rate that goes beyond the swap's reset period, like for example the 5-year swap rate. The second leg of the swap can be either a fixed rate or another floating rate, either based on a money market index, or another market swap rate.
A CMS can be used to speculate on, or hedge against, a change in the shape of the yield curve. When a bank or company believes for example that the three-month LIBOR rate will fall relative to the five-year swap rate for a given currency, it enters into a constant maturity swap paying the three-month LIBOR rate and receiving the five-year swap rate.
