The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

INTEREST RATE SWAPS

In an interest rate swap, two parties 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 principal. The dollar amount each counterparty pays to the other is the agreed-upon periodic interest rate times the notional principal. The only dollars that are exchanged between the parties are the interest payments, not the notional principal. 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 floating rate payer.

The reference rates that have been used for the floating rate in an interest rate swap are those on various money market instruments: Treasury bills, the London interbank offered rate, commercial paper, bankers acceptances, certificates of deposit, the federal funds rate, and the prime rate. The most common is the London interbank offered rate. LIBOR is the rate at which prime banks offer to pay on Eurodollar deposits available to other prime banks for a given maturity. Basically, it is viewed as the global cost of bank borrowing. There is not just one rate but a rate for different maturities. For example, there is a one-month LIBOR, three-month LIBOR, six-month LIBOR, ...