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2 - Interest Rate Swap

# 2 - Interest Rate Swap

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10/18/2013

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Interest rate swap
interest rateswap
is a derivativein which one party exchanges a stream of  interest   payments for another party's stream of cash flows. Interest rate swaps can be used byhedgerstomanage their fixedor floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swapsare very popular and highly liquid instruments.
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 Structure
In an interest rate swap, eachcounterpartyagrees to pay either a fixed or floating ratedenominated in a particular currency to the other counterparty.
The fixed or floating rate ismultiplied by a notional principal amount(say, USD 1 million).
This notional amount isgenerally not exchanged between counterparties, but is used only for calculating the size of cashflows to be exchanged.The most common interest rate swap is one where one counterparty A pays a fixed rate (theswap rate) to counterparty B, while receiving a floating rate (usually pegged to a reference ratesuch asLIBOR ).

A pays fixed rate to B (A receives variable rate)B pays variable rate to A (B receives fixed rate).Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 3.00%, in exchange for periodic variable interest rate payments of LIBOR  + 50  bps  (0.50%). Note that there is no exchange of the principal amounts and that the interest rates areon a "notional" (i.e. imaginary) principal amount. Also note that the interest payments aresettled in net (e.g. if LIBOR is 1.30% then Party B receives 1.20% (3.00% - (LIBOR + 50 bps))and Party A pays 1.20%). The fixed rate (3.00% in this example) is referred to as the swap rate.
At the point of initiation of the swap, the swap is priced so that it has anet present valueof zero. If one party wants to pay 50 bps above the par  swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.
 Types
BeingOTCinstruments interest rate swaps can come in a huge number of varieties and can bestructured to meet the specific needs of the counterparties. By far the most common are fixed-for-fixed, fixed-for-floating or floating-for-floating. The legs of the swap can be in the samecurrency or in different currencies. (A single-currency fixed-for-fixed rate swap is generally not possible; since the entire cash-flow stream can be predicted at the outset there would be noreason to maintain a swap contract as the two parties could just settle for the difference betweenthe present values of the two fixed streams; the only exceptions would be where the notionalamount on one leg is uncertain or other esoteric uncertainty is introduced).
 Fixed-for-floating rate swap, same currency
Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency Aindexed to X on a notional N for a term of T years. For example, you pay fixed 5.32% monthlyto receive USD 1M Libor monthly on a notional USD 1 million for 3 years.
The party thatpays fixed and receives floating coupon rates is said to be
long
the interest swap. Interestrate swaps are simply the exchange of one set of cash flows for another.
Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to afloating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10million loan at 5.3% paid monthly and a floating rate investment of USD 10 million that returnsUSD 1M Libor +25 bps monthly, it may enter into a fixed-for-floating swap. In this swap, thecompany would pay a floating USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in20bps profit.
 Fixed-for-floating rate swap, different currencies
Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency Bindexed to X on a notional N at an initial exchange rate of FX for a tenure of T years. For example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M(TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120)for 3 years. For nondeliverable swaps, the USD equivalent of JPY interest will be paid/received

(according to the FX rate on the FX fixing date for the interest payment day). No initialexchange of the notional amount occurs unless the Fx fixing date and the swap start date fall inthe future.Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability inone currency to a floating rate asset/liability in a different currency, or vice versa. For example,if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rateinvestment of JPY 1.2 billion that returns JPY 1M Libor +50 bps monthly, and wants to lock inthe profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up (JPYdepreciate against USD), then they may enter into a Fixed-Floating swap in different currencywhere the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, lockingin 30bps profit against the interest rate and the fx exposur.
 Floating-for-floating rate swap, same currency
Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate incurrency A indexed to Y on a notional N for a tenure of T years. For example, you pay JPY 1MLIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years.Floating-for-floating rate swaps are used to hedge against or speculate on the spread betweenthe two indexes widening or narrowing. For example, if a company has a floating rate loan atJPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30 bps andcurrently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has anet profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down (relative tothe LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) andwants to insulate from this risk, they can enter into a float-float swap in same currency wherethey pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps. With this, they haveeffectively locked in a 35 bps profit instead of running with a current 40 bps gain and indexrisk. The 5 bps difference (w.r.t. the current rate difference) comes from the swap cost whichincludes the market expectations of the future rate difference between these two indices and the bid/offer spread which is the swap commission for the swap dealer.Floating-for-floating rate swaps are also seen where both sides reference the same index, but ondifferent payment dates, or use different business day conventions. These have almost no usefor speculation, but can be vital for asset-liability management. An example would be swapping3M LIBOR being paid with prior non-business day convention, quarterly on JAJO (i.e. Jan,Apr, Jul, Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28 modified following
 Floating-for-floating rate swap, different currencies
Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate incurrency B indexed to Y on a notional N at an initial exchange rate of FX for a tenure of Tyears. For example, you pay floating USD 1M LIBOR on the USD notional 10 millionquarterly to receive JPY 3M TIBOR monthly on a JPY notional 1.2 billion (at an initialexchange rate of USDJPY 120) for 4 years.To explain the use of this type of swap, consider a US company operating in Japan. To fundtheir Japanese growth, they need JPY 10 billion. The easiest option for the company is to issuedebt in Japan. As the company might be new in the Japanese market without a well knownreputation among the Japanese investors, this can be an expensive option. Added on top of this,