Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

MEANING OF INTEREST RATE SWAP

An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. Interest rate swaps are over-the-counter instruments. In an interest rate swap, two parties agree to “swap” or exchange periodic interest payments. The amount of the interest payments exchanged is based on some predetermined principal also known as the notional principal. The amount one counterparty pays to the other is the agreed-upon periodic interest rate—either fixed or floating based on some agreed benchmark—applied on the notional principal. Only the interest component on the notional principal is exchanged between the parties and not the notional principal itself.

Typically, one party agrees to pay the other party fixed interest payments at designated dates for the life of the contract. This party is referred to as the fixed-rate payer. The other party, who agrees to make interest rate payments that float with some reference rate, is referred to as the fixed-rate receiver. Such swaps are referred to as fixed-for-floating rate swaps. The rates used for the floating leg of the interest rate swap are those on various money market instruments viz. treasury bills, the London interbank offered rate (LIBOR), commercial paper, the prime rate etc. The most common however is the LIBOR.

The notional principal for the swap can vary over the life of the swap. A swap in which the notional principal decreases ...