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Types of Interest Rate Swap

Types of Interest Rate Swap

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Published by Puneet Srivastav

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Published by: Puneet Srivastav on Jan 08, 2013
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TYPES OF INTEREST RATE SWAP
 
Being OTC instruments, interest rate swaps can come in a huge number of varieties and can bestructured to meet the specific needs of the counterparties. For example, the legs of the swap can bein the same currency or in different currencies. The notional of the swap could be amortized overtime. The reset dates of the floating rate could be non-regular, etc. However, in the interbank market, just a few, standardized types are traded. They are listed below. Each currency has its own standardmarket conventions regarding the frequency of payments, the day count conventions and the end-of-month rule.Normally the parties do not swap payments directly, but rather each sets up a separate swap with afinancial intermediary such as a bank. In return for matching the two parties together, the bank takesa spread from the swap payments (in this case 0.30% compared to the above example)
Fixed for Floating
 
Investors call the parts of interest swap agreements “legs.” In a fixed
-for-floating swap agreement,one party agrees to pay the fixed leg of the swap, with the other party agreeing to pay the floating legof the swap. The fixed rate is the interest charged over the life of a loan and does not change. Thefloating rate is an interest rate pegged to an international reference rate index and is subject tochange. The most commonly used reference rate is London Interbank Offered Rate or LIBOR.
Fixed-for-floating rate swap, same currency
Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floatingrate asset/liability or vice versa. For example, if a company has a fixed rate USD 10 million loan at5.3% paid monthly and a floating rate investment of USD 10 million that returns USD 1M Libor+25bps monthly, it may enter into a fixed-for-floating swap. In this swap, the company would pay afloating rate of USD 1M Libor+25bps and receive a 5.5% fixed rate, locking in 20bps profit.
Fixed-for-floating rate swap, different currencies
Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in onecurrency to a floating rate asset/liability in a different currency, or vice versa. For example, if acompany has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50bps monthly, and wants to lock in the profit in USD asthey expect the JPY 1M Libor to go down or USDJPY to go up (JPY depreciate against USD), thenthey may enter into a Fixed-Floating swap in different currency where the company pays floatingJPY 1M Libor+50bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rateand the FX exposure.

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