Interest Swaps

MEANING & TYPES
Interest rate swaps (IRS) are derivative contracts that allow parties to
exchange one stream of interest payments for another. They are
commonly used as a tool for hedging interest rate risk or for speculating on
future interest rate movements.
In an interest rate swap, two parties agree to exchange interest rate

payments on a notional amount of money. The notional amount is never
actually exchanged, but is used to calculate the size of the interest
payments. One party agrees to pay a fixed rate of interest, while the other
agrees to pay a floating rate of interest, usually based on a benchmark.
The fixed rate payer is typically seeking to hedge against rising interest
rates, while the floating rate payer is seeking to hedge against falling
interest rates. However, both parties may be motivated by a variety of
reasons, including speculation on future interest rate movements.
The market for interest rate swaps is predominantly an over-the-counter

(OTC) market, meaning that the contracts are privately negotiated
between parties rather than traded on an exchange. This allows for a high
degree of customization, as parties can tailor the terms of the swap to their
specific needs
1. Fixed-to-floating interest rate swap: A fixed-to-floating interest rate

swap is a type of interest rate swap in which one party agrees to pay a
fixed rate of interest to the other party, while the other party agrees to pay
a floating rate of interest based on a reference rate such as LIBOR or the
Fed Funds rate.
The party paying the fixed rate is usually looking to hedge against the risk
of rising interest rates, while the party paying the floating rate is typically
looking to benefit from any potential decrease in interest rates.
2. Floating-to-fixed interest rate swap: A floating-to-fixed interest rate

swap is the opposite of a fixed-to-floating swap. In this type of swap, one
party agrees to pay a floating rate of interest to the other party, while the
other party agrees to pay a fixed rate of interest.
This swap is often used when one party believes that interest rates will
decrease in the future and wants to lock in a fixed rate, while the other
party believes that interest rates will rise and is willing to pay a floating rate
in exchange for the potential benefits of higher interest rates.
3. Float-to-float interest rate swap: A float-to-float interest rate swap is
a type of swap in which both parties agree to exchange cash flows based
on two different floating interest rates.
This type of swap is often used to hedge against the risk of a mismatch
between two floating rates, such as when a company has liabilities based
on one floating rate but assets based on another. By entering into a float-
to-float swap, the company can effectively transform its liability to match its
assets, reducing its overall interest rate risk.
HISTORY
In 1981, IBM and the World Bank entered into a noteworthy swap
agreement, marking the first formalized swap of its kind. The World Bank
found itself in need of borrowing German marks and Swiss francs to
finance its operations, yet the respective governments of those countries
had prohibited its borrowing activities. On the other hand, IBM had already
borrowed significant amounts of those currencies but required U.S. dollars
when interest rates were high for corporate borrowers. Recognizing the
mutual benefit of the situation, Salomon Brothers proposed that the two
entities exchange their debts through a swap. Thus, IBM exchanged its
borrowed francs and marks for the World Bank's dollars, while further
managing its currency exposure with the mark and franc. Since then, this
swaps market has expanded exponentially to reach trillions of dollars
annually.
The history of swaps added another chapter during the 2008 financial
crisis when credit default swaps (CDS) on mortgage-backed securities
(MBS) were identified as a contributing factor to the widespread economic
downturn. Originally intended to offer protection for non-payment of
mortgages, the CDS market experienced defaults as the market began to
falter, leading to substantial financial reforms that addressed how swaps
are traded and how information on swap trading is disseminated. While
swaps were initially traded over the counter, they are now primarily traded
on centralized exchanges.
UNDERLYING INSTRUMENTS USED FOR EACH CURRENCY
The underlying instrument in an interest rate swap is the interest rate,

more specifically the interest rate on a notional principal amount. An
interest rate swap is a financial contract where two parties agree to
exchange interest rate payments based on a notional principal amount for
a specified period of time. The underlying instrument, in this case, is the
interest rate used to calculate the interest payments exchanged between
the two parties.
The notional principal amount is a hypothetical amount of money used to
calculate the interest payments, and it is not actually exchanged between
the parties involved in the swap. The interest rate swap can be used by the
parties involved to manage their interest rate risk. For example, if one
party has a floating interest rate on a loan, but expects that interest rates
will rise in the future, they may enter into an interest rate swap agreement
to exchange their floating rate for a fixed rate.
The interest rate used as the underlying instrument in an interest rate

swap can be based on a variety of benchmarks, such as LIBOR (London
Interbank Offered Rate) or the US Treasury rate.
The interest rate used in the swap is determined by the parties involved
and is based on their expectations of future interest rate movements.
LIBOR (London Interbank Offered Rate) is being discontinued, and as a

result, the financial industry is transitioning to new benchmark rates for
interest rate swaps and other financial contracts. The new benchmark
rates that are being used as an alternative to LIBOR vary by currency and
include:
These new benchmark rates are based on actual transactions in the

respective markets and are considered to be more robust and reliable than
LIBOR. As such, they are being adopted as the new underlying
instruments for interest rate swaps and other financial contracts.
1. US Dollar (USD): The underlying instrument for an interest rate swap

in USD is often based on the benchmark interest rate for US Treasury
securities, such as the 10-year Treasury note or the 30-year Treasury
bond.
2. Euro (EUR): The underlying instrument for an interest rate swap in

EUR is often based on the Euro Interbank Offered Rate (EURIBOR), which
is the benchmark interest rate used for interbank lending in the Eurozone.
3. British Pound (GBP): The underlying instrument for an interest rate

swap in GBP is often based on the Sterling Overnight Interbank Average
Rate (SONIA), which is the benchmark interest rate used in the UK money
markets.
4. Japanese Yen (JPY): The underlying instrument for an interest rate

swap in JPY is often based on the Tokyo Interbank Offered Rate (TIBOR),
which is the benchmark interest rate used for interbank lending in Japan.
5. Swiss Franc (CHF): The underlying instrument for an interest rate
swap in CHF is often based on the Swiss Average Rate Overnight
(SARON), which is the benchmark interest rate used in the Swiss money
markets.
6. The underlying instrument for an interest rate swap in India is

typically the Mumbai Interbank Forward Offer Rate (MIFOR) or the
Reserve Bank of India's (RBI) benchmark interest rate. MIFOR is a
benchmark interest rate used for Indian rupee (INR) denominated interest
rate swaps, which is calculated based on the interest rates on certificates
of deposit and commercial paper issued by Indian banks. MIFOR is used
as a reference rate for pricing and settling INR interest rate swaps.
7. In addition to MIFOR, the Reserve Bank of India (RBI) also publishes

benchmark interest rates, such as the Overnight MIBOR (Mumbai
Interbank Offer Rate) and the 10-Year Government of India Security Yield.
These rates can also be used as underlying instruments for interest rate
swaps in India, depending on the specific terms of the swap and the
market conventions.
PRESENTATION
MEANING:
Interest rate swaps are derivative contracts that allow parties to exchange one
stream of interest payments for another.
To put it in other words, two parties agree to exchange interest rate payments
on a notional amount if money. So here, the notional amount is never actually
exchanged but it is used to calculate the size of interest payments. One party
agrees to pay a fixed rate of interest while the other party agrees to pay a
floating rate of interest.
HISTORY:
The first interest rate swap took place between international business machines
(IBM) and the world bank In1981. The world bank was in need to German
marks and Swiss francs to finance its operations but the governments of those
countries had strictly prohibited its borrowing activities. On the other hand,
IBM had already borrowed a significant sum of those currencies. And it was in
need of US dollars but the interest rates for US dollars were too high for the
corporate borrowers. So by recognizing their mutual benefit, IBM and world
bank exchanged their debts through a swap.
In 1987, the International Swaps & Derivatives Association reported that the
swap market had a total notional value of $865.6 billion.
UNDERLYING INSTRUMENTS USED FOR EACH CURRENCY:

The interest rate used as the underlying instrument in an interest rate swap can
be based on a variety of benchmarks, such as LIBOR (London interbank offered
rate) but since it is being discontinued, the new benchmark rates that are being
used as an alternative to LIBOR vary by currency.
For US Dollar, the underlying instrument is based on the benchmark interest
rates for US treasury securities.
Underlying instrument for EURO is Euro interbank Offered Rate,
For British pound we have sterling overnight interbank average rate,
For Japanese yen we have Tokyo interbank offered rate
and for Indian rupees we have Mumbai Interbank Offer Rate.

Interest Swaps

Uploaded by

Copyright:

Available Formats

Interest Swaps

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Interest Swaps

Uploaded by

Copyright:

Available Formats

MEANING & TYPES

In an interest rate swap, two parties agree to exchange interest rate

The market for interest rate swaps is predominantly an over-the-counter

1. Fixed-to-floating interest rate swap: A fixed-to-floating interest rate

2. Floating-to-fixed interest rate swap: A floating-to-fixed interest rate

UNDERLYING INSTRUMENTS USED FOR EACH CURRENCY

The underlying instrument in an interest rate swap is the interest rate,

The interest rate used as the underlying instrument in an interest rate

LIBOR (London Interbank Offered Rate) is being discontinued, and as a

These new benchmark rates are based on actual transactions in the

1. US Dollar (USD): The underlying instrument for an interest rate swap

2. Euro (EUR): The underlying instrument for an interest rate swap in

3. British Pound (GBP): The underlying instrument for an interest rate

4. Japanese Yen (JPY): The underlying instrument for an interest rate

6. The underlying instrument for an interest rate swap in India is

7. In addition to MIFOR, the Reserve Bank of India (RBI) also publishes

UNDERLYING INSTRUMENTS USED FOR EACH CURRENCY:

Underlying instrument for EURO is Euro interbank Offered Rate,

For British pound we have sterling overnight interbank average rate,

For Japanese yen we have Tokyo interbank offered rate

and for Indian rupees we have Mumbai Interbank Offer Rate.

You might also like