Definition of 'Amortizing Swap'

An exchange of cash flows, one of which pays a fixed rate of interest and one of which pays a floating
rate of interest, and both of which are based on a notional principal amount that decreases. In an
amortizing swap, the notional principal decreases periodically because it is tied to an underlying
financial instrument with a declining (amortizing) principal balance, such as a mortgage.

The notional principal in an amortizing swap may decline at the same rate as the underlying or at a
different rate which is based on the market interest rate of a benchmark like mortgage interest rates or
the London Interbank Offered Rate. The opposite of an amortizing swap is an accreting principal swap -
its notional principal increases over the life of the swap. In most swaps, the amount of notional principal
remains the same over the life of the swap.

Definition of 'Forward Swap'

A swap agreement created through the synthesis of two swaps differing in duration for the purpose of
fulfilling the specific time-frame needs of an investor. Also referred to as a "forward start swap,"
"delayed start swap," and a "deferred start swap."

For example, if an investor wants to hedge for a five-year duration beginning one year from today, this
investor can enter into both a one-year and six-year swap, creating the forward swap that meets the
needs of his or her portfolio. Sometimes swaps don't perfectly match the needs of investors wishing to
hedge certain risks.

Constant Maturity Swap (CMS)

A variation of the fixed-rate-for-floating-rate interest rate swap. The rate on one side of the constant
maturity swap is either fixed or reset periodically at or relative to LIBOR (or another floating reference
index rate). The constant maturity side, which gives the swap its name, is reset each period relative to a
regularly available fixed maturity market rate. This constant maturity rate is the yield on an instrument
with a longer life than the length of the reset period, so the parties to a constant maturity swap have
exposure to changes in a longer-term market rate. Although published swap rates are often used as
constant maturity rates, the most popular constant maturity rates are yields on two- to five-year
sovereign debt. In the U.S., swaps based on sovereign rates are often called constant maturity Treasury
(CMT) swaps. A standard fixed-for-floating interest rate swap is priced to reflect the arbitrage-enforced
relationship between a fixed rate and the combined spot and forward rates implied by the yield curve. In
contrast, the CMS is priced to reflect the relative values of either fixed or floating rates on one side and
an intermediate-term fixed-rate instrument that covers a segment of the forward curve and moves out
along the forward curve at each reset date. The CMS arbitrage relationship is more complex than the
fixed-for-floating rate swap, but the principles that determine the pricing of other swaps apply to CMS.
In general, a flattening or an inversion of the curve after the swap is in place improves the constant
maturity rate payer's position relative to a floating rate payer. The relative positions of a constant
maturity rate payer and a fixed-rate payer are more complex, but the fixed-rate payer in any swap
benefits primarily from an upward shift of the yield curve

Interest Rate Caps, Floors and Collars

An interest rate cap is a contract where if interest rates exceed a certain strike rate, for an agreed upon
notional amount, the buyer will receive interest for the interest differential over the strike rate for the
given conversion period. Consider it insurance protection against rising interest rates. Caps are mainly
used by borrowers to protect them from raising interest rates.

The critical elements of an interest rate cap are listed below:

· Strike Rate – The trigger rate where payment is to the purchaser if market rates exceed it. The rate
can be a set percentage, or an underlying reference index rate (usually LIBOR) or a reference rate plus a
spread. It’s the ceiling exposure if rates increase.

· Notional Amount – The underlying principle amount. The notional amount can also have an
amortization schedule attached.

· Start Date – The commencement date

· Settlement Date - Payment date

· Interest Calculation – There are various acceptable interest calculations, such as the actual number
of days / 360 or 365.

Example: Lenders often rely on interest rates caps to protect their margins from unexpected interest
rate increases. These companies originate many fixed rate term loans or leases. Their new business
volume is usually initially funded by floating rate revolving debt, and then securitized at a later date.
They always have a certain amount of volume debt sitting in their revolver. Management, however,
often chooses not to absorb the full cost of swaps, but is willing to pay the “insurance premiums” for
caps, to protect its portfolio from a spike in short-term funding rates. The caps set the upper limits that
the companies are exposed to if interest rates increase. Their P&L’s are exposed to interest rate hikes,
up to the strike rate.

An interest rate floor is the opposite of a cap. It’s a contract that is written with a specified notional
amount and a predetermined strike rate. The buyer gets paid if the market interest rate drops below the
strike rate. It protects the purchaser (usually the borrower) from falling interest rates. Floors are
particularly useful for lenders with adjustable rate assets and fix rate debt.

Let’s assume you have a lender issuing floating rate (adjustable) loans and capitalized with fixed rate
debt, usually bonds. The lender would buy a floor to protect him if interest rates dropped. If the interest
rate decreases below the strike rate, the company would be paid for the interest differential. In effect,
as the loans were re-priced downward, the floor would somewhat protect the margins. Caps and floors
won’t completely lock in your profits, but they do reduce risk.

An interest rate collar is a combination play of purchasing a cap (or floor) and selling a floor (or cap). The
strike prices are set within a band. The structure is used because the proceeds received by selling the
floor (or cap) offset the cost of the cap (or floor).

Definition of 'Basis Rate Swap'

A type of swap in which two parties swap variable interest rates based on different money markets. This
is usually done to limit interest-rate risk that a company faces as a result of having differing lending and
borrowing rates.

For example, a company lends money to individuals at a variable rate that is tied to the London
Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference
between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis
rate swap, where they exchange the T-Bill rate for the LIBOR rate, they eliminate this interest-rate risk.
Corridor Swap

An interest rate swap that is designed so that payment obligations occur only when the reference rate is
within some specified range or “corridor”. The corridor swap is sort of a speculation on the volatility of
the floating rate (usually LIBOR). For example, a firm could enter into a swap to receive a fixed rate and
pay a floating rate (say a 6-month LIBOR) only when LIBOR is in the range of 3%-6%, i.e., in case it is
greater than 3% but lower than 6%.

Corridor swaps are also used in Forex markets. In this sense, a corridor swap (or bonus swap) involves
the payment of a best case interest rate below par if an exchange rate sticks to a preset corridor, and a
worst-case above par if the exchange rate slips out that corridor.