A swap is an agreement between two institutions to exchange future cash flows. Suppose there is a bank receiving fixed 8% return on 2 year money lent. This bank can swap its revenue stream against another firm’s variable rate 2 year money. In practice swaps tend to be more complicated and can involve more simultaneous variations of interest rates and currency as well. When settled, only the differential between the would-be payments are exchanged between two parties and not the principal. IRS are generally unknown to the public at large as they are relatively unregulated OTC derivatives that don’t trade on public exchanges. Definition
An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction: there is no foreign exchange component to be taken account of. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.
Interest Rate Swap Situation
A bank needs to balance its floating interest rate portfolio with more fixed rate loans, so it contacts a company who has a high percentage of fixed rate loans and offers to do an interest rate swap. Interest Rate Swap Terms
The two companies negotiate and, depending on the current economic climate and the prevailing interest rates, one party might have to pay one-quarter of a point or so above the usual swap rate to get the deal done. A duration for the swap is decided which is genereally 1-15 years, then settlement dates specified and the settlement period begins.
Settlement dates are when it is time to pay up if your end of the swap was the loser. Until the settlement dates, no money ever changes hands with swaps. On this day, the party whose interest was higher collects the difference from the party whose interest was less. Generally settlements are done annually.
Example of Interest Rate Swap
Let's say Bank A and Bank B make a 3 year interest rate swap deal where they put up 10 million each with annual settlement dates.
L+2% Bank A agrees to pay Bank B 4 percent fixed interest, and Bank B agrees to pay Bank A the one year LIBOR (London Interbank Offering Rate -- a variable rate commonly used in swaps) plus 2 percent. After 1 year, on the day of settlement, Bank A owes Bank B 400,000, and assuming that LIBOR was 1.8 percent, then Bank B owes Bank A only 380,000, meaning that the only money to change hands will be Bank A paying Bank B, the $20,000 difference.
A company with the highest credit rating, AAA, will pay less to raise funds under identical terms and conditions than a less creditworthy company with a lower rating, say BBB. The incremental borrowing premium paid by a BBB company, is greater in relation to fixed interest rate borrowings than it is for floating rate borrowings and this spread increases with maturity. Hence, the counterparty making fixed rate payments in a swap is predominantly the less creditworthy participant. The other reasons are: Regulations prevailing in the market for a particular company and the saturation of portfolio of a bank or a company with too much of fixed interest payments. USES
An important benefit of interest rate swaps it their ability to hedge risk for financial institutions. For example, a company may seek to avoid interest rate risk using an interest rate swap. This is because fractional variances in interest rates can have significant impact on the cost, and benefit of a well-thought-out interest rate swap agreement.
Large businesses also use...