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

MEANING OF RECEIVE FLOATING AND PAY FIXED TYPE OF INTEREST RATE SWAP

Pay fixed and receive floating swap

In this type of interest rate derivative, the pay leg will be a fixed rate and the receive leg will be based on some benchmark interest rate like LIBOR. Suppose that for the next five years party A agrees to pay party B 5 percent per year, while party B agrees to pay party A three-month LIBOR + 50 basis points. Assume that the notional principal is $10 million, and that payments are exchanged every three months for the next five years. Party A is the fixed-rate payer, while party B is the fixed-rate receiver. So every three months, party A (the fixed-rate payer) will pay party B $125,000 (5 percent on $10 million for the quarter). Party B (the fixed-rate receiver) on the other hand will pay party A an amount calculated at 3-month LIBOR + 50 basis points on the same $10 million applicable for the quarter. Assuming that the 3-month LIBOR is say 5.25 percent, party B will pay party A $143,750 (5.25 + 0.50 percent on $10 million for the quarter).

Interest rate swap as a hedging instrument

Being a derivative instrument, an interest rate swap per se qualifies as a hedging instrument. It should be noted that in an interest rate swap, the risk reward is symmetric and can be more or less compared to an equity futures position. An interest rate swap instrument can be used to hedge primarily interest rate risk.

It should be noted that the derivative financial instrument of an interest ...