INTEREST RATE SWAPS
An interest rate swap provides a vehicle for market participants to transform the nature of cash flows and the interest rate exposure of a portfolio, balance sheet, particular asset or liability, or structured transaction.
In an interest rate swap, two parties (called counterparties) agree to exchange periodic interest payments. The dollar amount of the interest payments exchanged is based on some predetermined dollar principal, which is called the notional amount. The dollar amount each counterparty pays to the other is the agreed-upon periodic interest rate times the notional amount. The only dollars that are exchanged between the parties are the interest payments, not the notional amount. Accordingly, the notional principal serves only as a scale factor to translate an interest rate into a cash flow. In the most common type of swap, one party agrees to pay the other party fixed interest payments at designated dates for the life of the contract. This party is referred to as the fixed rate payer. The other party, who agrees to make interest rate payments that float with some reference rate, is referred to as the fixed rate receiver.
The reference rates that have been used for the floating rate in an interest rate swap are various money market rates: Treasury bill rate, London interbank offered rate, commercial paper rate, bankers acceptances rate, certificates of deposit rate, federal funds rate, and prime rate. The most common is the London Interbank ...