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Trading and Capital-Markets Activities Manual

Instrument Profiles: Interest-Rate Swaps
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Interest-rate swaps are over-the-counter (OTC) derivative contracts in which two parties agree to exchange interest cash flows or one or more notional principal amounts at certain times in the future according to an agreed-on formula. The cash flows may be in the same currency or a different currency. The formula defines the cash flows using one or more interest rates and one or more hypothetical principal amounts called notional principal amounts. 

As an example, suppose that Company A and Bank B enter into a three-year interest-rate swap, in which Bank B agrees to pay a 6 percent fixed rate (quoted on a 30/360-day count basis) on a notional principal of $100 million, every six months, on January 1 and July 1. In return, Company A agrees to pay U.S. dollar six-month LIBOR on the same dates, on the same notional principal. Thus, the cash flows on the swap will have semi-annual fixed rate payments of $300,000 going to Company A on each January 1 and July 1, and floating payments based on the prevailing level of U.S. dollar six-month LIBOR on each January 1 and July 1 going to Bank B. These semi-annual cash flows will be exchanged for the three-year life of the swap. 

Banks, corporations, sovereigns, and other institutions use swaps to manage their interest-rate risks, reduce funding costs (fixed or floating), or speculate on interest-rate movements. Banks (commercial, investment, and merchant) also act as swaps dealers or brokers in their role as financial intermediaries. As a dealer, a bank offers itself as a counterparty to its customers. As a broker, a bank finds counterparties for its customers, in return for a fee. 

The interest-rate swaps market has grown rapidly since its inception in the early 1980s. As of March 1995, interest-rate swaps accounted for 69 percent of the market in interest-rate derivatives, in terms of notional principal outstanding. The notional principal outstanding in swaps at this date was $18.3 trillion. The gross market value of these swaps was $562 billion, or 87 percent of all interest-rate derivative contracts. 

CHARACTERISTICS AND FEATURES 

Swap Terminology and Conventions 

An interest-rate swap is an off-balance-sheet, OTC contractual agreement in which two counterparties agree to make interest payments to each other, based on an amount called the notional principal. In an interest-rate swap, only the interest payments are exchanged; the notional principal is not exchanged, it is used only to calculate the interest payments. Each counterparty's set of payments is called a leg or side of the swap. The fixed-rate payer has bought the swap, or is long the swap. Conversely, the floating-rate payer has sold the swap, or is short the swap. The counterparties make service payments at agreed-on periods during the swap's tenor. The payer of a fixed leg makes service payments at a fixed price (or rate). The payer of a floating leg makes payments at a floating price that is periodically reset using a reference rate, which is noted on specific reset dates. The actual dates on which payments are made are payment dates. 

The reference floating rate in many interest-rate swap agreements is the London Interbank Offered Rate (LIBOR). LIBOR is the rate of interest offered on short-term interbank deposits in Eurocurrency markets. These rates are determined by trading between banks, and they change continuously as economic conditions change. One-month, three-month, six-month, and one-year maturities are the most common for LIBOR quoted in the swaps market. Other floating-rate indexes common to the swaps market include prime, commercial paper, T-bills, and the 11th District Cost of Funds Index (COFI). 

A day count convention for the fixed-rate and floating-rate payments is specified at the beginning of the contract. The standard convention is to quote the fixed leg on a semi-annual 30/360-day basis, and to quote LIBOR on an actual/360-day basis. The fixed and floating legs, however, can be quoted on any basis agreed to by the counterparties. 

The date that the swap is entered into is called the trade date. The calculation for the swap starts on its settlement date (effective or value date). Unless otherwise specified in the agreement, the settlement date on U.S. dollar interest-rate swaps is two days after the trade date. The swap ends on its termination or maturity date. The period of time between the effective and termination dates is the swap's tenor or maturity. 

Swap Agreement 

Swaps are typically initiated through telephone conversations and confirmed by fax, telex, or letter (a confirmation). Both parties are legally bound by the initial agreement and complete documentation is not exchanged until later. Swap contracts are usually executed according to the standards of the International Swaps and Derivatives Association (ISDA) or the British Bankers Association's Interest-Rate Swaps (BBAIRS). The complete documentation of a particular swap consists of the confirmation; a payment schedule (in a format standardized by ISDA or BBAIRS); and a master swap agreement that uses standard language, assumptions, and provisions. As a rule, counterparties execute one master agreement to cover all their swaps. Thus, two different swaps may have different confirmations and payment schedules but may use the same master agreement. The master agreements cover many issues, such as (1) termination events; (2) methods of determining and assessing damages in case of default or early termination; (3) netting of payments; (4) payment locations; (5) collateral requirements; (6) tax and legal issues; and (7) timely notification of changes in address, telex numbers, or other information. 

Types of Swaps 

This general swap structure permits a wide variety of generic swaps. Common types of interest-rate swaps are outlined below. 

  The generic (or plain vanilla) swap has a fixed and a floating leg; the notional amount and payments are all in the same currency. 
  The basis (or floating-for-floating) swap has two floating legs, each tied to a different reference rate. These instruments are often used to reduce basis risk for a balance sheet that has assets and liabilities based on different indexes. 
  The forward swap has a settlement at some agreed-on future date. A forward swap allows counterparties to lock in a fixed rate (as a payer or receiver) at the time of contract origination, but to postpone the setting of the floating rate and the calculation of cash flows until some time in the future. These swaps are often used to hedge future debt refinancings or anticipated issuances of debt. 
  The amortizing swap has a notional principal which is reduced at one or more points in time before the termination date. These swaps are often used to hedge the interest-rate exposure on amortizing loans, such as project-finance loans. 
  The accreting swap has a notional principal which is increased at one or more points in time before the termination date. These swaps are often used to hedge the interest-rate exposure on accreting loans, such as the drawdown period on project-finance loans. 
  The zero-coupon swap is a fixed-for-floating swap in which no payments are made on the fixed leg until maturity. These swaps are often used to hedge the exposure on a zero-coupon instrument. 
  Callable, putable, and extendible swaps are swaps with embedded options in which one party has the right, but not the obligation, to extend or shorten the tenor of the swap. As the counterparty has sold an option to the swap dealer in these transactions, the swaps will have a lower fixed rate in the case of a fixed-rate payer and a higher fixed rate in the case of a fixed-rate receiver. The counterparty is, however, subject to call or extension risk. 
  The seasonal swap has different payment dates for the two legs (which may both be fixed), usually tied to the counterparties' cash-flow needs. These swaps are often used to create synthetic cash flows when actual cash flows change over time. This technique is called deseasoning. For example, suppose Firm A expects to make $120 million a year, or on average $10 million a month, but also expects to earn on average $15 million a month in June, July, and August; $5 million a month in May, September, and October; and $10 million a month in the remaining months. It can enter into a seasonal swap in which it pays $5 million a month in June, July, and August, when its revenues are high, and receives $5 million a month in May, September, and October, when its revenues are low. 

USES 

Interest-rate swaps are used for hedging, investment, and speculative purposes. Interest-rate swaps are also used to reduce funding costs and arbitrage purposes. Examples of how banks use interest-rate swaps for asset/liability management, investment purposes, and speculation are shown below. 

Asset/Liability Management: Closing the Balance-Sheet Gap 

Suppose a bank has a $30 million, five-year, fixed-rate loan asset with a semi-annual coupon of 12.5 percent which it has funded with $30 million of money market deposits. The bank is faced with a balance-sheet gap-the asset has a fixed rate of interest, but the cost of the underlying liability resets every week. The risk faced by the bank is that a rise in short-term interest rates will cause the cost of its liabilities to rise above the yield on the loan, causing a negative spread. The bank can use a fixed-for-floating interest-rate swap to achieve a closer match between its interest income and interest expense, thereby reducing its interest-rate risk (see figure 1). 

As shown in figure 1, the bank has entered into a five-year interest-rate swap in which it pays a dealer 12 percent and receives three-month U.S. dollar LIBOR. In effect, the bank has locked in a positive spread of 50 basis points. 

Cash Flows on Transaction 

Assumed cost of money 
market deposits (pays) -3-month LIBOR 
Swap inflow (receives) +3-month LIBOR 
Swap outflow (pays) -12.00% 
Loan interest inflow (receives) +12.50% 

Net position with hedge +50 basis points 

While the bank has effectively locked in a positive 50 basis point spread, it remains subject to basis risk between the three-month U.S. dollar LIBOR rate which it is receiving in the swap and the weekly money market rates which it pays to its depositors. 

Investment Uses: Transforming a Fixed-Rate Asset into a Floating-Rate Basis 

Interest-rate swaps are often used by investment managers to create synthetic assets, often in response to temporary arbitrage opportunities between the cash and derivative markets. A plain vanilla interest-rate swap can be used to transform the yield on a fixed- (floating-) rate asset such as a corporate bond into a floating-(fixed-) rate asset. 

As an example, suppose that the investment manager of Company B has a five-year fixed-rate bond which yields 13.5 percent. Also, suppose that the investment manager has a strong view that interest rates will rise, but does not want to sell the bond because its credit quality could improve substantially in the future. To position the portfolio for a rise in rates without selling the bond, the investment manager can enter into an interest-rate swap in which Company B pays a fixed rate of 12 percent and receives a floating rate based on the 90-day T-bill rate, effectively creating a synthetic floating-rate security yielding the 90-day T-bill rate plus 150 basis points (see figure 2). 

Figure 1

ASSET

Cash Flows on Transaction 

Fixed rate on bond (receives) +13.50% 
Fixed rate on swap (pays)       -12.00% 
Floating-rate 90-day T-bill 
(receives)                                  +90-day T-bill 

Net Rate Received by Company B 90-day T-bill + 1.50% 

Speculation: Positioning for the Expectation of Rate Movements 

Interest-rate swaps can be used to take a position on interest-rate movements. In this example, an end-user establishes positions with swaps, believing that interest rates will fall in a six-month period. The end-user believes that short-term interest rates will decrease, but does not want to sell its floating-rate asset. The end-user can therefore enter into an interest-rate swap to receive a fixed rate of interest and pay a floating rate of interest, thereby converting the floating rate asset to a fixed-rate basis. 

Figure 3 shows the cash flow to an end-user who has a $100,000 asset indexed to LIBOR, under various interest-rate scenarios for a period of six months. The vertical axis shows the end-user's net cash flow after six months, and the horizontal axis shows different interest-rate exposure strategies, ranging from holding the asset without entering into interest-rate swaps to entering into swaps to pay LIBOR and receive a fixed rate. 

In each of the three clusters of bars on the horizontal axis, the return to the end-user under different interest-rate scenarios is displayed (from left to right) for no change in interest rates, a 2.00 percent decrease in interest rates, and a 2.00 percent increase in interest rates. As can be seen from the middle bar in the first cluster (the ''no swaps'' scenario), if the investor is correct and short-term interest rates decrease, the return on the asset will fall dramatically. The second cluster of bars on the horizontal axis (the ''1 swap'' scenario) shows the asset return after the investor has entered into one 

Figure 3-Using Plain Vanilla Swaps to Leverage Interest-Rate Exposure


swap based on a notional principal amount of $100,000 (equal to the amount invested in the asset), in which the investor pays a floating rate and receives a fixed rate. This swap is effectively a hedge which transforms the floating-rate asset return to a fixed-rate basis so that the asset return remains constant under all interest-rate scenarios. 

The third cluster of bars on the horizontal axis (the ''3 swaps'' scenario) demonstrates the return from the investor's ''leveraged'' speculation that short-term interest rates will decrease. Here, the investor enters into three interest-rate swaps based on a notional principal of $100,000 (which is equivalent to one swap based on a notional principal of $300,000), in which the investor pays a floating rate and receives a fixed rate. Again, the first swap effectively transforms the floating-rate asset to a fixed-rate basis; in the second and third swaps, the investor receives (pays) the differential between the fixed and floating rates in the swap. Hence, if interest rates decrease 2.00 percent and the investor has entered into three interest-rate swaps (the middle bar in the third cluster), the asset return is increased substantially compared to just holding onto the asset (the middle bar in the first cluster). However, if the investor is wrong, and interest rates increase 2.00 percent after three interest rates have been entered into, the return on the asset will be zero.

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