An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

13

Interest Rate Swaps

13.1 CHAPTER OVERVIEW

This chapter explores one of the fundamental tools of the modern capital markets, the interest rate swap (IRS). A standard or ‘plain’ vanilla IRS is an agreement between two parties to exchange cash flows on regular payment dates. One leg is based on a fixed rate of interest and the return leg on a variable or floating rate of interest. The chapter considers how payments on the swap are calculated. It looks at the trading and hedging applications for corporate borrowers and institutional investors. Nowadays the market for swaps is extremely competitive and dealers working for major banks stand ready to quote two-way prices in a wide variety of currencies for a range of maturities (up to 30 years and beyond) and for a range of payment frequencies. The chapter discusses swap spreads which measure the relationship between the fixed rates on swaps and the returns on benchmark government securities. Spreads are affected by credit risk considerations, by liquidity, and also by supply and demand factors. Many issuers of fixed coupon bonds use swaps to switch their liabilities to a floating rate basis. The chapter considers why this is so and where the benefits lie. The final topic is cross-currency swaps, in which payments are made in two different currencies. The Appendix lists non-standard swap varieties.

13.2 SWAP DEFINITIONS

In the most general terms a swap is a contract between two parties:

• agreeing to exchange cash flows;

• on ...