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

6

Interest Rate Swaps

INTRODUCTION

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

• agreeing to exchange cash flows;

• on regular dates;

• where the two payment legs are calculated on a different basis.

A swap is a bilateral over-the-counter (OTC) agreement directly negotiated between two parties, at least one of which is normally a bank or other financial institution. Once made, the contract cannot be freely traded. On the other hand, it can be tailored to meet the needs of a particular counterparty. As with other OTC derivatives there is a potential credit risk - the risk that the other party to the deal might default on its obligations.

Clearing Arrangements for OTC Derivatives

Following the 2007/8 ‘credit crunch’ regulators in the US and elsewhere have pressed derivatives dealers to increase the use of central clearing arrangements for OTC derivative trades such as swaps. This involves registering an OTC transaction with a clearing house which then acts as central counterparty, taking collateral and guaranteeing the deal against the risk of default. This topic is discussed further in Chapter 20.

In an equity swap (see Chapter 7) one payment leg is based on the price of a single stock or on the level of a stockmarket index such as the S&P 500. In a commodity swap one leg is based on the price of a physical commodity such as oil. In an interest rate swap (IRS) both payment legs are based on interest rates.

Swaps of all kinds are used by corporations, investors and ...