Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 6. Interest Rate Swaps

INTRODUCTION

A swap is a contract between two parties agreeing to exchange payments on regular future dates for a defined period of time, where the two payment legs are calculated on a different basis. The most common type of interest rate swap (IRS) is a fixed/floating deal in which the payment made by one party is based on a fixed rate of interest, and the return payment is based on a variable or floating rate. The floating rate is reset periodically according to a benchmark such as the London Interbank Offered Rate (LIBOR).A variant on this type of structure is the cross-currency swap in which the payments are made in two different currencies, based on floating or fixed interest rates.

In an equity swap one payment leg is based on the change in the value of a share, or a basket of shares, or an equity index such as the S&P 500 or the FT-SE 100 (see Chapter 7). In a commodity swap one leg is based on the value of a physical commodity such as oil. Swaps of all kinds are used by corporations, by investing institutions and by banks to manage their exposures to interest rates, currencies, share values, commodity prices and loan default rates. They can also be used to take speculative trading positions.

STERLING INTEREST RATE SWAP

The most common type of interest rate swap is the fixed/floating swap, often referred to as a 'plain vanilla' deal. The characteristics of a vanilla IRS contract are as follows:

• The notional principal is fixed at the outset and never ...