Interest rate swaps (IRS) are private OTC derivative contracts that are typically agreed between large financial institutions and corporations. IRS contracts allow participants to exchange short-term cash flows from fixed income assets in the same currency. The spread between the IRS and short-term interbank rates is seen as a key indicator of market sentiment. As the swap curve reflects both LIBOR expectations and bank lending, this is a strong indicator of bond market conditions. In some cases, the swap curve has supplanted the Treasury curve as the main benchmark for pricing and trading corporate bonds, loans and mortgages. Interest rate swaps have become an indispensable tool for many types of investors, as well as for corporate treasurers, risk managers and banks, as they have many potential applications. These include: An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another over a period of time. Swaps are derivative contracts and are traded over-the-counter. For the construction of curves, see: [5] [6] [2] Under the old frame, a single self-actualized curve was “bootstrapped”, that is, resolved in such a way that it returned exactly the observed prices of the selected instruments – the IRS, with FRA at the short end – the construction operating sequentially, in terms of dates, through these instruments. According to the new framework, the different curves are better adapted to the observed market prices – as a “set of curves” – one discount curve, one for each IBOR content “forecast curve”, and the structure is then based on the prices of the IRS and OIS. Since the average overnight observed rate is exchanged for the -IBOR rate over the same period of time (the most liquid content on this market) and the -IBOR-IRS are in turn discounted on the OIS curve, the problem involves a non-linear system in which all points of the curve are solved at the same time and special iterative methods are usually used – very often a modification of Newton`s method. Other tenor curves can be solved in a “second step” in the bootstrap style.
This process continues until the swap reaches maturity and final payments are calculated. Companies sometimes enter into a swap to change the type or duration of the floating rate index they pay. This is called a basic exchange. For example, a company may switch from a three-month LIBOR to a six-month LIBOR, either because the interest rate is more attractive or because it is compatible with other cash flows. A company can also move on to another index, such as. B the federal funds rate, commercial paper or treasury bill rate. There are three different types of interest rate swaps: fixed to float, float to fixed and float to float. The swap rate chart over all available maturities is called the swap curve, as shown in the following chart.
Since swap rates include an overview of future expectations for LIBOR, as well as market perception of other factors such as liquidity, supply and demand dynamics, and bank credit quality, the swap curve is an extremely important interest rate benchmark. Since real movements in interest rates do not always match expectations, swaps carry interest rate risk. Simply put, a beneficiary (the counterparty that receives a fixed cash flow) benefits when interest rates fall and loses when interest rates rise. Conversely, the payer (the counterparty that pays fixed interest rates) wins when interest rates rise and loses when interest rates fall. The IRS treaty exists over a period of time (usually measurable in years). It starts with its value date (although it is not the contract date) and is considered no longer active after its expiry date. Meanwhile, there is an exchange of cash flows, which are calculated by looking at the profitability of each party. These are based on an amount that is not actually traded, but is used fictitiously for the calculation (and therefore called notional amount), and a rate that is set either when the swap is created (for the fixed partial amount) or at a reference interest rate called during the swap (for the floating leg). An example of a benchmark interest rate could be something like “LIBOR 3M”. Like most non-sovereign fixed income investments, interest rate swaps involve two main risks: interest rate risk and credit risk, known as counterparty risk in the swap market.
A vanilla IRS is the term used for standardized IRS. Typically, these have none of the above adjustments and instead feature constant fictitious and implicit payment and accumulation data, as well as currency-based calculation conventions. [2] A vanilla IRS is also characterized by the fact that one leg is “fixed” and the second leg “floating”, indicating an index -IBOR. The net present value (PV) of a vanilla IRS can be calculated by separating and adding the PV of each fixed leg and floating leg. For the price of a mid-market IRS, the underlying principle is that both legs must first have the same value. see below under Rational Pricing. Given these concerns, banks typically charge for a credit rating adjustment as well as other valuation adjustments x that then incorporate these risks into the value of the instrument. Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or relationships between them.
Traditionally, bond investors who expected interest rates to fall bought bonds in cash, the value of which increased as interest rates fell. Today, investors with a similar view could enter into a floating swap against a fixed interest rate; If interest rates fall, investors will pay a lower variable rate in exchange for the same fixed rate. At the time of the swap arrangement, the total value of the fixed interest rate flows of the swap is equal to the value of the expected floating rate payments involved in the libor futures curve. As future LIBOR expectations change, so does the fixed interest rate that investors charge for entering into new swaps. Swaps are usually quoted at this fixed interest rate or alternatively in the “swap spread”, which is the difference between the swap rate and the equivalent yield on local government bonds for the same maturity. There is no consensus on the scope of the naming convention for different types of IRS. Even a broad description of IRS contracts only includes those whose legs are denominated in the same currency. It is generally accepted that swaps of a similar nature, whose legs are denominated in different currencies, are called cross-currency base swaps.
Swaps that are determined by a floating rate index in one currency, but whose payments are denominated in another currency, are called quantos. In January 1989, the Commission sought the legal advice of two Queen`s Counsel. Although they disagreed, the Commission preferred to consider that it was ultra vires for the Councils to make interest rate swaps (i.e. they did not have the legal power to do so). In addition, interest rates have risen from 8% to 15%. The Auditor and the Commission then went to court and had the contracts annulled (appeals to the House of Lords failed in Hazell v. Hammersmith and Fulham LBC); The five banks involved lost millions of pounds. Many other local authorities had carried out interest rate swaps in the 1980s. [13] This has led to several cases in which banks have generally lost their compound interest claims on debts owed to municipalities concluded in Westdeutsche Landesbank Girozentrale v Islington London Borough Council. [14] However, banks recovered some funds where derivatives for advice were “in the money” (i.e., an asset that shows a profit for the board that it now had to return to the bank, not debt). As otc instruments, interest rate swaps (IRS) can be adjusted and structured in a variety of ways to meet the specific needs of counterparties. For example: payment dates may be irregular, the nominal value of the swap may pay for itself over time, reset dates (or fixed dates) of the variable interest rate may be irregular, mandatory termination clauses may be inserted into the contract, etc.
A common form of adjustment is often present in new issue swaps, where fixed equity cash flows are designed to replicate the cash flows they have received in the form of coupons for a purchased bond. However, the interbank market has only a few standardized types. The USD interest rate swap market is closely linked to the Eurodollar futures market, which is traded on the Chicago Mercantile Exchange, among others. Suppose PepsiCo needs to raise $75 million to acquire a competitor. In the U.S., they may be able to borrow the money at an interest rate of 3.5%, but outside the U.S., they may only be able to borrow 3.2%. The catch is that they would have to issue the bond in a foreign currency subject to fluctuations based on the interest rates of the home country. A company that does not have access to a fixed-rate loan can borrow at a variable rate and enter into a swap to reach a fixed interest rate. Variable interest period, reset and loan payment data are reflected and cleared on the swap. The fixed-interest portion of the swap becomes the company`s borrowing rate. The FixedLeg includes all the details of the CommonLeg, as well as the details of the payer, the rate at which the Leg is set and the date role agreement (i.e. what to do if the calculated date lands on a holiday or weekend). The actual description of an interest rate swap (IRS) is a derivative contract between two counterparties that specifies the type of payment exchange in relation to an interest rate index.
The most common IRS is a fixed floating swap, where one party makes payments to the other party based on a fixed interest rate initially agreed to receive arrears based on a variable interest rate index. Each of these paylines is called a “leg,” so a typical IRS has both a firm leg and a floating leg. The variable index is usually an interbank offered rate (IBOR) with a specific maturity in the corresponding IRS currency, e.B LIBOR in GBP, EURIBOR in EUR or STIBOR in SEK. . . . .