Derivatives

CHAPTER 33Interest Rate Swaps

Aims

• To show how plain vanilla interest rate swaps can be used to convert uncertain future floating-rate interest cash flows into known fixed-rate cash flows (or vice versa).
• To examine the role of swap dealers, settlement procedures, pricing schedules and the termination of swap agreements.
• To demonstrate how cash payoffs in the swap are determined.
• To demonstrate the principle of comparative advantage – the source of gains in a swap.

Swaps are privately arranged contracts (i.e. OTC instruments) in which parties agree to exchange cash flows in the future according to a prearranged formula. Swap contracts originated in about 1981. The largest market is in interest rate swaps but currency swaps are also widely used.

The most common type of interest rate swap is a plain vanilla fixed-for-floating rate swap. Here one party agrees to make a series of fixed interest payments to the counterparty, and to receive a series of payments based on a variable (floating) interest rate (LIBOR). The interest payments are based on a stated notional principal of say , but only the interest payments are exchanged each period, not the principal value – hence the use of ‘notional’. The payment dates, day-count convention, maturity of the swap, and the floating rate to be used (usually LIBOR) are also determined at the outset of the contract. In a plain vanilla swap ‘the ...