Interest Rate Swaps and Their Derivatives: A Practitioner's Guide

CHAPTER 2

Swaps: It′s Still About Discounting

Aplain-vanilla fixed-for-floating Interest Rate Swap (IRS) is an over-the-counter (OTC) agreement between 2 counterparties to periodically exchange interest payments on a hypothetical loan, where one counterparty, the fixed-rate payer, pays a periodic fixed coupon, while the other counterparty, the floating rate payer, pays a variable amount that periodically resets on a benchmark interest rate index, for example, 3-month London Interbank Offered Rate (Libor) for USD, which is considered to be the funding index for banks. As opposed to a bond, each counterparty only pays the interest payments on the hypothetical loan, and no principal payment is made either at the beginning or end of the swap, hence the name interest rate swap. Figure 2.1 shows the cash flows of a simple 1-year USD swap with fixed-rate C.

When talking about plain-vanilla fixed-for-floating swaps—swaps from now on—the point of reference is the fixed rate. If one is receiving the fixed rate (floating-rate payer), one is said to be receiving in a swap or simply receiving. Similarly if one is the fixed-rate payer, then one is paying in a swap, or simply paying. Receiving in a swap is akin to being long a bond, since one is receiving a coupon and paying periodic financing (3m-Libor rather than overnight or term repo). Similarly, paying in a swap is akin to being short a bond.

The stream of cash flows made by each counterparty (fixed/floating payer) is referred to as a ...