Handbook of Finance: Financial Markets and Instruments

Chapter 40. Interest Rate Swaps

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

GERALD W. BUETOW, PhD, CFA

President and Founder, BFRC Services, LLC

Abstract: One of the major innovations in the financial markets has been the interest rate swap. This instrument is a derivative product that was introduced into the financial markets in the early 1980s. Interest rate swaps were first used to try to arbitrage opportunities in global capital markets. While those arbitrage opportunities quickly disappeared, the interest rate swap market continued to grow. Today, this derivative instruction provides asset managers, risk managers, corporate treasurers, and municipal treasurers with an efficient tool for controlling interest rate risk by altering the cash flow characteristics of their assets or liabilities.

Keyword: interest rate swap, plain vanilla swap, fixed-rate payer, swap fixed rate, swap rate, fixed-rate receiver, floating-rate receiver, floating-rate payer, cash flow for the swap, swap spread, swap dealer, counterparty risk, amortizing swap, accreting swap, basis swap, constant maturity swap (CMS), forward rate swap, swaption, payer's swaption, receiver's swaption

The objective of this chapter is to explain the basic features of an interest rate swap and provide an economic interpretation of this derivative instrument. Interest rate swaps include plain vanilla swaps, amortizing swaps, accreting swaps, basis swaps, constant maturity swaps, ...