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In an interest rate swap, each counterparty agrees to pay either a fixed or floa
ting rate denominated in a particular currency to the other counterparty. The fi
xed or floating rate is multiplied by a notional principal amount (say, $1 milli
on) and an accrual factor given by the appropriate day count convention. When bo
th legs are in the same currency, this notional amount is typically not exchange
d between counterparties, but is used only for calculating the size of cashflows
to be exchanged. When the legs are in different currencies, the respective noti
onal amounts are typically exchanged at the start and the end of the swap, which
is called cross currency interest rate swap.
The most common interest rate swap involves counterparty A paying a fixed rate (
the swap rate) to counterparty B while receiving a floating rate indexed to a re
ference rate like LIBOR, EURIBOR, or MIBOR. By market convention, the counterpar
ty paying the fixed rate is the "payer" (while receiving the floating rate), and
the counterparty receiving the fixed rate is the "receiver" (while paying the f
loating rate).
A pays fixed rate to B (A receives floating rate)
B pays floating rate to A (B receives fixed 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 fixe
d interest rate payments of 8.65% in exchange for periodic variable interest rat
e 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 "notiona
l" (i.e., imaginary) principal amount. Also note that interest payments are sett
led in net; that is, Party A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45%
net. The fixed rate (8.65% in this example) is referred to as the swap rate.[2]
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 thi
s.
As OTC instruments, interest rate swaps can come in a number of varieties and ca
n be structured to meet the specific needs of the counterparties. For example, t
he legs of the swap could be in same or different currencies; the notional of th
e swap could be amortized over time; reset dates (or fixing dates) of the floati
ng rate could be irregular.
The interbank market, however, only has a few standardized types which are liste
d below. Each currency has its own standard market conventions regarding the fre
quency of payments, the day count conventions and the end-of-month rule.[3]
Fixed-for-floating rate swap, different currencies[edit]
For example, if a company has a $10 million fixed rate loan at 5.3% paid monthly
and a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50
bps every month, and wants to lock in the profit in USD as they expect the JPY 1
M Libor to go down or USDJPY to go up (JPY depreciate against USD), then they ma
y enter into a fixed-for-floating swap in different currencies where the company
pays floating JPY 1M Libor+50bps and receives 5.6% fixed rate, locking in 30bps
profit against the interest rate and the FX exposure.
Floating-for-fixed rate swap, same currency[edit]
Fixed-for-floating rate swap, same currencies[edit]

Floating-for-fixed rate swap, different currencies[edit]

Fixed-for-fixed rate swap, same currency[edit]
Floating-for-floating rate swap, same currency[edit]
Party P pays/receives floating interest in currency A indexed to X to receive/pa
y floating rate in currency A indexed to Y on a notional N for a tenure of T yea
rs. 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 different tenors, are the most liquid and most commonly
traded same currency floating-for-floating swaps..
Floating-for-floating rate swaps are used to hedge against or speculate on the s
pread between the two indexes. For example, if a company has a floating rate loa
n at JPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR +
30bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this
company has a net profit of 40bps. If the company thinks JPY 1M TIBOR is going
to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the
future (relative to the TIBOR) and wants to insulate from this risk, they can e
nter into a float-float swap in same currency where they pay, say, JPY TIBOR + 3
0bps and receive JPY LIBOR + 35bps. With this, they have effectively locked in a
35bps profit instead of running with a current 40bps gain and index risk. The 5
bps difference (w.r.t. the current rate difference) comes from the swap cost whi
ch includes the market expectations of the future rate difference between these
two indices and the bid-offer spread, which is the swap commission for the deale
r.
Floating-for-floating rate swaps are also seen where both sides reference the sa
me index, but on different payment dates, or use different business day conventi
ons. This can be vital for asset-liability management. An example would be swapp
ing 3M LIBOR being paid with prior non-business day convention, quarterly on JAJ
O (i.e., Jan, Apr, Jul, Oct) 30, into FMAN (i.e., Feb, May, Aug, Nov) 28 modifie
d following.
Fixed-for-fixed rate swap, different currencies[edit]
Party P pays/receives fixed interest in currency A to receive/pay fixed rate in
currency B for a term of T years. For example, you pay JPY 1.6% on a JPY notiona
l of 1.2 billion and receive USD 5.36% on the USD equivalent notional of $10 mil
lion at an initial exchange rate of USDJPY 120.
Floating-for-floating rate swap, different currencies[edit]
Party P pays/receives floating interest in currency A indexed to X to receive/pa
y floating rate in currency B indexed to Y on a notional N at an initial exchang
e rate of FX for a tenure of T years. The notional is usually exchanged at the s
tart and at the end of the swap. This is the most liquid type of swap with diffe
rent currencies. For example, you pay floating USD 3M LIBOR on the USD notional
10 million quarterly to receive JPY 3M TIBOR quarterly on a JPY notional 1.2 bil
lion (at an initial exchange rate of USDJPY 120) for 4 years; at the start you r
eceive the notional in USD and pay the notional in JPY and at the end you pay ba
ck the same USD notional (10 million) and receive back the same JPY notional (1.
2 billion).
For example, consider a U.S. company operating in Japan that needs JPY 10 billio
n to fund its Japanese growth. The easiest way to do this is to issue debt in Ja
pan, but this may be expensive if the company is new in the Japanese market and
lacking a good reputation among the Japanese investors. Additionally, the compan
y may not have the appropriate debt issuance program in Japan or may lack a soph
isticated treasury operation in Japan. The company could issue USD debt and conv
ert to JPY on the FX market. This option solves the first problem, but it introd
uces two new risks:

FX risk: If this USDJPY spot goes up at the maturity of the debt, then when the
company converts the JPY to USD to pay back its matured debt, it receives less U
SD and suffers a loss.
USD JPY interest rate risk: If JPY rates come down, the return on the investment i
n Japan may also go down, introducing interest rate risk.
The FX risk can be hedged with long-dated FX forward contracts, but this introdu
ces yet another risk where the implied rate from the FX spot and the FX forward
is a fixed but the JPY investment returns a floating rate. Although there are se
veral alternatives to hedge both exposures effectively without introducing new r
isks, the easiest and most cost-effective alternative is to use a floating-for-f
loating swap in different currencies.
Other variations[edit]
A number of other far less common variations are possible. Mostly tweaks are mad
e to ensure that a bond is hedged "perfectly", so that all the interest payments
received are exactly offset, which can lead to swaps where the principal is pai
d 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
Uses[edit]
Interest rate swaps are used to hedge against or speculate on changes in interes
t rates.
Speculation[edit]
Interest rate swaps are also used speculatively by hedge funds or other investor
s who expect a change in interest rates or the relationships between them. Tradi
tionally, fixed 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 floating-for-fixed interest rate swap; as rates fall, investors w
ould pay a lower floating rate in exchange for the same fixed rate.
Interest rate swaps are also popular for the arbitrage opportunities they provid
e. Varying levels of creditworthiness means that there is often a positive quali
ty spread differential that allows both parties to benefit from an interest rate
swap.
The interest rate swap market in USD is closely linked to the Eurodollar futures
market which trades among others at the Chicago Mercantile Exchange.
British local authorities[edit]
In June 1988 the Audit Commission was tipped off by someone working on the swaps
desk of Goldman Sachs that the London Borough of Hammersmith and Fulham had a m
assive exposure to interest rate swaps. When the commission contacted the counci
l, the chief executive told them not to worry as "everybody knows that interest
rates are going to fall"; the treasurer thought the interest rate swaps were a "
nice little earner". The Commission's Controller, Howard Davies, realised that t
he council had put all of its positions on interest rates going down and ordered
an investigation.
By January 1989 the Commission obtained legal opinions from two Queen's 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 r
ates had increased from 8% to 15%. The auditor and the commission then went to c
ourt 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 five banks involve
d lost millions of pounds. Many other local authorities had been engaging in int
erest rate swaps in the 1980s.[4] This resulted in several cases in which the ba
nks generally lost their claims for compound interest on debts to councils, fina

lised in Westdeutsche Landesbank Girozentrale v Islington London Borough Council

.[5]