Interest Rate Swaps

Interest rate swaps are often by investors who expect a change in the interest rates. Interest rates swaps can be fixed or floating rates. The rates are tied to an individual principal amount that is not exchanged by the parties. At the time of contract there is no advantage to either party and therefore no upfront payment is required. The rate is multiplied by each principal and the difference between the two is exchanged. Interest rate swaps are often used to manage risk due to interest rate fluctuation.

Main Types

Fixed for Floating Rate – A party agrees to receive/pay a currency tied to a predetermined fixed rate in exchange agrees to receive/pay a currency tied to an index. The index and currencies are agreed upon by the parties.

Floating for Floating Rate – A party agrees to pay a currency valued by some index and agrees to receive a currency valued by some other index. Each index and currency can be agreed upon by the parties.

Fixed for Fixed Rate - This type of swap is generally not in the same currency but each party agrees to pay a fixed rate in currency A for a fixed rate in currency B. The rates are negotiated by the parties involved.

Other varations are possible

The present value of the swap rate can be calculated using the equations below.

The formulas for the fixed and floating rates are shown below.

PV_{float} = ∑ (P x f_{i} x t_{i}/T_{i x df,i})

PV_{fixed} = C x ∑ (P x t_{i}/T_{i x df,i})

C = PV_{float}/∑ (P x t_{i}/T_{i x df,i})

C = the swap rate

P = principal amount

t_{t} = number of days in the period

T_{t} = basis according to the day count convention

df_{i}= discount factor, and fi is the forward rate.

Risks:

Interest rate risk originates from changes in the floating rate.

Credit risk is present due to possible default from a party.

References:

http://www.interestrateswaps.info/swap_valuation.htm

http://www.bis.org/publ/econ35.htm

http://www.bmocm.com/products/marketrisk/intrderiv/interestswaps/default.aspx

http://en.wikipedia.org/wiki/Interest_rate_swap