Interest rate swaps
Interest rate swap is a type of derivative, so its value depends on underlying assets, for example, interest rates or equity. In few words we can describe swaps as exchange of one type of asset, cash flow, investment, liability, or payment for another. The parties that agrees to swap are known as counterparties.
Swaps are OTC (over-the-counter) derivatives, so the their market is quite unregulated. It means that trades are not taking place on exchange and there is no regulatory bodies or clearing houses that will make sure each part will fulfil counter parties' commitments. This makes Swaps more risky than other derivatives. Some work to increase safety is being done by ISDA * International Swap and Derivatives Association but ISDA cannot impose conditions and regulations.
Interest rate swaps characteristics
Commonly know as plain vanilla swaps. It is an agreement in which two parties agree to swap their exchange obligations. Each party makes periodically payment to the other on the specified date, during set period of time. Usually, interest rate swaps exchange a fixed payment for a floating payment - often linked to an interest rate (ex.LIBOR). The first interest rate swap occurred in 1981 in agreement between IBM and World Bank. Since that time the market grown up rapidly.
Example of interest rate swap
Company who took a floating rate loan * based on LIBOR might be worried that, with the increase of LIBOR, the interest rates will also go up. So it decides swap its floating rate for a fixed one.
The company borrowed 1,000 Euros on floating rate Libor+50bp. And swap it for fixed rate. The company agrees to pays Bank a fixed 7% in return Bank will pay them LIBOR rate. They have swapped variable rate liability for fixed without changing their originally loan so without making changes into their balance sheet.
Let say that LIBOR is: 8%.
- Company pays to lender: 850 Euros
- Company pays to the Bank: 700 Euro
- Company receive: 800 Euro from Bank.
- The total effect is that company receives 100 Euros from Bank & Pays 850 to lender, so pays only 750 Euros Net. And it does not matter if the rates go up or down company has fixed their rates.
Other types of swaps
- Currency Swaps
- Basis Swaps
- Total Return Swaps
- Credit Default Swaps
- Cooper, I. A., & Mello, A. S. (1991). The default risk of swaps. The Journal of Finance, 46(2), 597-620.
- Grinblatt, M. (2001). An analytic solution for interest rate swap spreads. International Review of Finance, 2(3), 113-149.
- Kolb, R. W., & Overdahl, J. A. (1997). Futures, options, and swaps. Oxford: Blackwell.
- Minton, B. A. (1997). An empirical examination of basic valuation models for plain vanilla US interest rate swaps. Journal of Financial Economics, 44(2), 251-277.
Author: Katarzyna Wierzbinska