Interest Rate Markets: A Practical Approach to Fixed Income

Chapter 5

Interest Rate Swaps

This chapter introduces another variation on the standard bond concept in the fixed income market: swaps. Swaps are one of the most ubiquitous financial derivatives around, encompassing markets as diverse as equities, commodities, and interest rates. In general, they are used to exchange one type of cash flow for another even if individual forms may differ across markets. For fixed income markets, swaps generalize the bond concept beyond a borrower and lender to interest payments of different types exchanged between any two parties. The most common swap in the rates space, referred to as a plain-vanilla swap, exchanges floating cash flows that vary based on the 3-month London Interbank Offered Rate (3M LIBOR) for fixed payments. One can imagine this as an exchange between parties: “You pay me 5 percent interest for the next two years, and I will pay you 3M LIBOR rate every three months for two years.” The payer of the fixed rate may believe rates are about to rise; hence receiving floating makes sense. The receiver of the fixed rate may instead like the certainty of receiving fixed payments or may be confident that rates will not rise. The rates world was one of the earliest users of swaps, starting in the early 1980s to manage risks arising from floating rates. Over time, the use of swaps has expanded considerably to manage a wide range of risks and to speculate on interest rate movements. This chapter discusses the underlying principles in detail ...