Interest Rate Swap

An interest rate swap is an unregulated over-the-counter (OTC) derivative contract between two parties to exchange one stream of interest payments for another. These contracts are valid for a specific period and are usually used to exchange fixed-rate interest payments for floating-rate interest payments on dates specified by the parties. While fixed interest rates are determined by the expected interest rates, floating rates are pegged to a base rate such as the LIBOR (London Interbank Offered Rate).

An interest rate swap is based on a notional principal amount, which is used to calculate the amount payable by both the parties. However, this principal amount in never exchanged<.

Interest rate swaps are used by commercial banks, insurance companies, investment banks, lenders, mortgage companies and government agencies. A typical interest rate swap transaction has a corporation, an investor or a bank on one side and an investment firm or a commercial bank on the other.

Interest rate swaps are fast gaining popularity among investors, speculators and banks, as these transactions are mostly based on market expectations for interest rates. While the total notional value of the swap market was $865.6 billion in 1987, it exceeded the $250 trillion mark by mid-2006, according to the International Swaps and Derivatives Association.

Types of Interest Rate Swap

There are several types of interest rate swaps:

Fixed-for-floating rate swap in same currency: This type of swap allows one party to pay fixed interest payments, while receiving payments from the other party in floating interest rates and vise versa. This is the most popular form of rate swaps and is called a vanilla swap.

 

Floating-for-floating rate swap in same currency: This type of interest rate swap is used when floating rates are based on different reference rates. For example, one interest rate could be pegged to the LIBOR, while another to the TIBOR (Tokyo Interbank Offered Rate). Companies opt for this type of swap to reduce the floating interest rate applicable to them and receive higher variable interest payments. It also helps to extend the maturity date of loans.

 

Fixed-for-fixed rate swap: This swap is used only when both parties are dealing in different currencies and involves the exchange of interest payments carrying predetermined rates. This swap helps international companies benefit from lower interest rates available to domestic consumers and avoid currency conversion costs.

 

Benefits of Interest Rate Swap

The benefits of interest rate swaps are:

Portfolio mangers can regulate their exposure to interest rates and alter the yield curve in a favorable direction.

Speculators can benefit from a favorable change in interest rates.

Since interest rate swaps do not involve the exchange of the principal amount, it eases the transaction.

Companies with fixed rate liabilities can enter into swaps to enjoy the benefits of floating rates and vise versa, based on the prevailing economic scenario.

Financial institutions can use these swaps to overcome interest risk exposure and remain profitable.