A swap is a cash-settled OTC derivative under which two counterparties exchange two streams of cash flows. It is called an interest rate swap if both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations. The most popular interest rate swaps are fixed-for-floating swaps under which cash flows of a fixed rate loan are exchanged for those of a floating rate loan. Among these, the most common use a 3-month or 6-month Libor rate (or Euribor, if the currency is the Euro) as their floating rate. These are called vanilla interest rate swaps. There is also a liquid market for floating-floating interest rate swaps—what are known as basis swaps. To keep things simple (and minimize settlement risk), concurrent cash flows are netted. In a typical arrangement. both loans have an initial payment (loan) of principal, but those net to 0. Both loans have a final return of the same principal, but those also net to 0. Also, the periodic interest payments are generally scheduled to occur on concurrent dates, so they too can be netted. The principal amount is called the notional amount of the swap. Consider an example. Two banks enter into a vanilla interest rate swap. The term is four years. They agree to swap fixed rate USD payments at 4.6% in exchange for 6-month USD Libor payments. At the outset, the fixed rate payments are known. The first floating rate payment is also known, but the ret will depend on future values of Libor. Exhibit 1 calculates the swap payments under a hypothetical scenario for Libor rates over the life of the swap. These are illustrated graphically in Exhibit 2.
In addition to being the financial equivalent of an exchange of loans, a vanilla fixed income swap is also mathematically equivalent to a strip of FRA's. Interest rate swaps are used for many purposes. If a corporation has borrowed money at a floating rate of interest but would prefer to lock in a fixed rate, it can swap its floating rate payments into fixed rate payments. This is illustrated in Exhibit 3.
Interest rate swaps can also be used to speculate on interest rates. A trader who believes that interest rates will rise could incur the expenses of borrowing and then shorting bonds. A simpler and less expensive solution would be to put on a pay-fixed swap. Vanilla interest rate swaps are quoted in terms of the fixed rate to be paid against the floating index. The fixed rate is usually quoted as an absolute rate, so a quote of 4.3% against 3-month Libor would indicate that the fixed rate would be 4.3% paid quarterly. The floating rate is always "flat"—that is, any spreads are added or subtracted from the fixed rate only. In USD markets, vanilla swaps are often quoted, not as an absolute rate, but as the fixed rate's spread over the corresponding Treasury yield. In the interdealer market, bid-ask spreads on vanilla interest rate swaps are typically one or two basis points. The fixed rates on vanilla swaps are called swap rates. The swap curve is a yield curve comprising swap rates for different maturities of swap. Due to high liquidity in the USD swap market, the swap curve has emerged as an alternative to Treasuries as a benchmark for USD interest rates at maturities exceeding a year.
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