Interest rate swap(Interest Rate Swap, IRS) - an agreement under which two parties exchange periodic interest payments in relation to a certain amount of principal debt, which is called a notional amount. Usually one party makes such interest payments at , and receives - at .

That is, on a predetermined date (or dates, if it involves the exchange of payments at certain intervals during the contract period), one party will pay another payment calculated on the basis of a fixed interest rate, and in return receive a payment calculated on the basis of a floating interest rate (for example, at a rate). In practice, such payments and one of the parties pays only the difference of the above payments.

There are several options for interest rate swaps. In particular, they include:

• exchange of payments with a fixed rate for payments with a floating one;
• exchange of payments with a fixed rate for payments with a fixed rate;
• exchange of floating rate payments for floating rate payments.

Future interest rate agreement(English Forward Rate Agreement, FRA) - a standardized interest rate swap.

Interest rate swaps are usually used for (insurance) transactions with assets and liabilities for the mutual transfer of fixed rates to floating rates and vice versa. Interest rate swaps are very popular and highly liquid instruments. This allows them to be used for .

With the help of a swap, the parties involved get the opportunity to exchange fixed-interest (fixed) obligations for obligations with a floating interest rate and vice versa. The need to make such an exchange may arise, for example, due to the fact that a company that has issued a fixed interest obligation expects interest rates to fall in the future. Therefore, as a result of the exchange of a fixed interest rate for a floating one, the company will be able to relieve itself of part of the financial burden of debt servicing. On the other hand, a company that has issued a floating rate bond and expects interest rates to rise in the future may avoid increasing its debt service payments by swapping the floating rate for a fixed rate.

Since different participants in economic relations assess the future conjuncture differently, there will also be opportunities for such exchanges. At the same time, the attractiveness of an interest rate swap lies not only or not so much in the ability to insure against adverse changes in future interest rates, but in the ability to issue debt at a lower interest rate.

An interest rate swap is characterized by the following features:

1. An interest rate swap is an exchange of interest payments, the amount of which is determined using different formulas, based on the notional principal amount of the agreement.
2. The swap does not provide for the exchange of principal - the participants in the swap do not lend to each other and do not borrow.
3. Counter-interest payments are usually set off, and only the difference between them is paid.
4. The swap has no effect on the underlying loan or deposit. A swap is a stand-alone transaction.

Positions that need to be negotiated when entering into an interest rate swap agreement include the following:

1. Effective date. The date from which interest begins to accrue on both sides of the swap. For simple interest rate swaps, this is the spot rate and the LIBOR rate fixed on the date of the transaction. The conditions here are the same as in the case of money market deposits.
2. Date of completion. The expiration date of the contract or repayment for which the final interest payment is calculated.
3. Conditional amount. The amount used to calculate the interest payments of both parties.
4. Fixed rate payer/beneficiary. Since in most swaps the payments are made by both parties, in one case at a fixed rate and in another at a floating rate, referring to the counterparties as "buyer" and "seller" can be misleading. In this regard, one of the counterparties is usually referred to as the payer of the fixed rate, and the other as the recipient of the fixed rate.
5. The basis for calculating the interest rate. Includes all the elements needed to calculate interest payments, including:
   • benchmark interest rate, such as LIBOR;
   • payment periods and dates;
   • number of days in a year to calculate.
6. Commission for the organization of the transaction.

The interest rate swap position contains interest and credit risks for the parties to the contract.

An interest rate swap is the most common type of swap. It is an agreement on the exchange of interest rates.
An interest rate swap consists of exchanging a debt with a fixed interest rate for a debt with a floating rate.
The persons participating in the swap exchange only interest payments, but not face values. Payments are made in a single currency. Under the terms of the swap, the parties undertake to exchange payments over a number of years. Typically, the duration of the swap ranges from 2 to 15 years. One party pays amounts that are calculated on the basis of a fixed (fixed) interest rate on the face value fixed in the contract, and the other party pays amounts according to a floating percentage of this face value. LIBOR is often used as a floating rate in swaps.
With the help of a swap, the parties involved get the opportunity to exchange fixed-interest (fixed) obligations for obligations with a floating interest rate and vice versa.
The need to make such an exchange may arise, for example, due to the fact that a firm that has issued a fixed-interest obligation expects interest rates to fall in the future. Therefore, as a result of the exchange of a fixed interest rate for a floating one, the firm will be able to relieve itself of part of the financial burden of debt servicing. On the other hand, a company that has issued a floating rate bond and expects interest rates to rise in the future may avoid increasing its debt service payments by swapping the floating rate for a fixed rate.
Since different participants in economic relations assess the future conjuncture differently, there will also be opportunities for such exchanges. At the same time, the attractiveness of an interest rate swap lies not only or not so much in the ability to insure against adverse changes in future interest rates, but in the ability to issue debt at a lower interest rate.

The simplest explanations of the nature of the swap
An example of a simple swap. Consider a hypothetical interest rate swap entered into on July 10, 2008 between companies A and B. Company A believes that interest rates will rise over the next three years, and company B that they will fall. Suppose Company A agreed to pay Company B an interest rate of 5% per annum on the principal amount of $100 million. In return, Company B agreed to pay Company A six-month LIBOR at the same principal rate.
Let's say that the companies exchange payments every six months (for three years), while the 5% rate is charged every six months.

The first exchange of payments took place on January 10, 2009, that is, six months after the conclusion of the agreement. Company A must pay $2.5 million to Company B. In turn, Company B must pay Company A interest income, accrued for $100 million at the six-month LIBOR rate established on 07/10/2008. Let six-month LIBOR then equal 4.2% per annum. That is: 0.5? 4.2? 100 = $2.1 million. Note that the amounts of the first exchange are known in advance.
The second exchange should take place on 10.07.2009. Company A is known to pay Company B $2.5 million again. On January 10, 2009, the fixed six-month LIBOR rate is 4.8%. So Company B will pay Company A $2.4 million.
Table 1 lists all payments and receipts under the three-year swap for company A, which supposedly have already taken place.

Table 1. Payments and receipts under a three-year swap of company A

the date	Six-month LIBOR (%)	Cash received under LIBOR	Amounts of money paid at a fixed rate	Difference
10.07.2008	4,20
10.01.2009	4,80	+2,10	-2,50	-0,40
10.07.2009	5,30	+2,40	-2,50	-0,10
10.01.2010	5,50	+2,65	-2,50	+0,15
10.07.2010	5,60	+2,75	-2,50	+0,25
10.01.2011	5,90	+2,80	-2,50	+0,30
10.07.2011		+2,95	-2,50	+0,45

We see that company A entered into a profitable swap for itself, since the difference in payments and receipts turned out to be in its favor. The LIBOR rate had a steady upward trend over a three-year period.

Using a swap to convert liabilities
An example of converting liabilities. Let Company A borrow $100 million at LIBOR pole 10 basis points (ie LIBOR + 0.1%). Analysts of company A came to the conclusion that the LIBOR rate will increase in the next three years.

In such a case, Company A could swap its floating interest debt for fixed interest debt. And she finds a second participant for the swap, company B, which has borrowed at 5.2% fixed. The participants in the swap agreed among themselves that company A would pay a fixed percentage of 5% per annum to company B twice a year, and company B would pay six-month LIBOR to company A every six months (see Fig. 2.). If LIBOR does increase over the next three years, Company A will be able to reduce its payments. But if LIBOR falls, what does Company B win?

Applying a swap to transform assets
An example of asset conversion. Let's consider the opposite situation. Let company A have bonds worth $100 million, which will bring her 4.7% per annum. Company B, on the other hand, has bonds that earn it a fixed LIBOR interest rate of 0.2 LIBOR. Companies A and B can transform their assets using a swap, say, according to this scheme (Fig. 3). AT this case, increase will go to the benefit of company A, and vice versa.


Role of financial intermediaries
As a rule, many companies, especially non-financial ones, do not directly enter into swap negotiations. Each of them communicates with a financial intermediary who enters into transactions with companies regarding swaps (brings companies into a swap) and receives three or four basis points for his services (ie 0.03 or 0.04%). In this case, the transaction shown in Fig. 2 is converted into the trade shown in Fig. four.

In this case, the financial intermediary earns a profit of 0.03% accrued in the amount of $100 million.
The opportunity to realize comparative advantage is present in the market. For example, it is easier for banks to issue obligations with a fixed interest rate, and for companies - with a floating one. As a result of the exchange of these obligations, the costs of the parties associated with entering the relevant markets are reduced, and the profitability of their operations is increased.
Another common type of swap is the currency swap.
A currency swap is an exchange of par and fixed interest in one currency for par and fixed interest in another currency.
Sometimes real exchange denomination may or may not occur. The implementation of a currency swap can be due to various reasons:
? currency restrictions on currency conversion;
? the desire to eliminate currency risks;
? the desire to issue bonds in the currency of another country in conditions where a foreign issuer is little known in this country, and therefore the market for this currency is directly inaccessible to him.

Success in financial terms implies education and knowledge in this area. In order not to lose your opportunities to earn money, you need to know how exactly you can do it. In this article, we will look at what swap (swap) transactions with foreign currency are and in what situations they can be used.

What is a swap deal?

A swap transaction is a financial transaction based on the exchange of one currency for another. In this case, the exchange agreement is concluded in both parties. On a certain date, a currency is bought, and on another, its reverse exchange is a sale. Moreover, this transaction usually implies pre-known conditions for buying and selling currency, they can be either the same or different.

However, it is not always very easy to understand what a swap transaction means. In order to understand this and better understand how it works, examples are needed. A few of them will be presented below.

Let's look at a few examples where this concept can come in handy. So you can better understand how it works, and in what cases it can help you.

FX Swap: Deal Example

There is an investor who has the opportunity to make a profitable transaction by buying bonds in the amount of 1 million dollars. According to the terms of this deal, he will be able to make a profit of 5% in one year, that is, 50 thousand dollars. However, the problem is that bonds are sold for dollars, while the investor's money is kept in euros.

In this case, he has several options for the development of the situation.

Consider the simplest and, perhaps, the first one that comes to mind - currency exchange. The bank offers the investor to buy currency from him at the rate, for example, 1.350. At the same time, in a year, he will be able to sell this currency back to the bank at a different rate. At the time of the sale, he could have sold the same currency at 1.345.

Calculate the amount of investment in euros by dividing by the current exchange rate. We get 741 thousand euros for 1 million dollars. In this case, one year after receiving a profit from the transaction, namely 50 thousand dollars, it is necessary to convert the money back into euros.

By simple calculations, we get that if the rate rises above 1.417, then with the reverse transaction you will already receive small losses. This is bad, because initially everything was planned only in order to make a profit. Depending on the exchange rate in this case is very impractical.

This means that it is necessary to look for other ways to solve this problem. To do this, you can use the swap deal.

For such a transaction, the bank offers the following conditions:

• Purchase of 1 million dollars now at the rate of 1.350, that is, for 741 thousand euros.
• Sale of 1 million dollars in a year at the rate of 1.355, that is, for 738 thousand euros.

At the same time, you still have your 50 thousand dollars of profit from the deal with the purchase of bonds. Their conversion into euros will already depend on the market rate, but you, as an investor, still remain in the black.

If during this time the rate has grown in favor of the investor, then the net profit will be more than 37 thousand euros. And at the same time, there are no risks and dependence on the course.

Yes, of course, if the rate changes to a more profitable one for you, this will mean that you could earn more. However, the risks you would have to take are not justified.

As you can see, a swap transaction with foreign currency gives the investor confidence that his investment will be justified and will not cause losses when exchanging currencies. In this situation, both parties remain in the black, both the investor, who insures himself against the risks of losing money, and the bank, which receives a specific profit from the transaction.

The bank knows that it will now give $1 million at one rate, and then buy them back at an already known rate and make a profit of 3,000 euros. And at the same time, he will remain with his money, lose nothing and risk nothing.

There is also such a thing as an interest rate swap.

This is an agreement between two parties, which is concluded with the condition of making payments both on the one hand and on the other with a certain percentage.

Interest is calculated depending on the terms of the transaction and is different for both parties. To make it clearer what it is, let's look at the example of an interest rate swap.

For example, the World Bank needs a long-term loan in francs. At the same time, the interest rate for such lending from a Swiss bank is too high. But at the same time, the bank has the opportunity to attract, for example, a long-term loan in rubles from the Russian Bank, which, for example, can borrow francs at a better interest rate and needs to replenish ruble capital.

To solve this problem, banks can begin to cooperate through an interest rate swap.

In this case, banks take the loans described above and exchange currencies, while paying a certain percentage. After the expiration of the term of the concluded agreement, banks make a reverse transaction.

As a result, both parties are in the black, as they received the desired amounts at a lower interest rate and did not lose a lot of money.

As you can see, swap deals are very useful in many cases. Their application can be found in many areas and for different purposes. It is very important to understand all the intricacies and nuances of transactions in order not to miss anything important.

Summing up

A swap transaction is a process of exchange between two parties of different, or rather opposite, currency conversion transactions.

In this case, one party receives confidence in receiving a fixed profit, and the other - a guarantee of a constant exchange rate during a reverse currency exchange. Moreover, this rate (both buying and selling) is determined in advance, at the conclusion of the transaction, and may even contain the same purchase and sale costs.

Swap transactions are a good solution for saving money. A currency swap allows you to know a specific rate before the actual exchange. You know in advance how much you will give for a certain amount, and how much you will receive for it later. The bank, in turn, knows in advance how much profit it will receive. Both sides do not take risks and do not depend on exchange rate fluctuations.

Interest rate swap - English Interest Rate Swap, a contract between two parties for the exchange of interest payments, which are for a predetermined and specified amount in the contract, called the contract amount. That is, on a predetermined date (or dates if the swap involves the exchange of payments at regular intervals during the contract period), one party will pay another payment calculated on the basis of a fixed interest rate, and in return receive a payment calculated on the basis of a floating interest rate (for example , at LIBOR rate). In practice, such payments are netted and one of the parties pays only the difference between the above payments.

Among the advantages of interest rate swaps is that they make it possible to reduce the cost of raising and servicing a loan. For example, a borrower with a fixed-rate loan option wants to take out a loan with floating-rate interest, but is unable to obtain such a loan on favorable terms. However, there is another borrower who has an advantage in obtaining a loan with floating interest rates, but who wishes to receive a loan at a fixed interest rate. In this case, the parties may enter into an interest rate swap, which provides for the exchange of payments, which are calculated on the basis of fixed and floating interest rates on the loan amount. As a rule, the parties do not exchange the principal amounts of the contract, but only transfer payments calculated on the basis of the difference in contractual interest rates.

Consider an interest rate swap as an example.

The first swap counterparty (company) can take out a loan of USD 10 million with a maturity of 3 years at a fixed rate of 12% or with a variable rate equal to LIBOR +1%.

The Bank can obtain credit resources in the interbank market in the same amount and for the same period with a variable interest rate equal to LIBOR or with a fixed rate of 10%.

In this case, the difference between fixed interest rates is greater than the difference between variable rates by 1%.

To conclude a swap, the company takes a loan with an interest rate equal to LIBOR + 1%, and the bank - with an interest rate of 10%.

After the conclusion of the swap, the bank periodically pays the company a floating interest - LIBOR, and the company periodically pays the bank a fixed interest - 10.5% (0.5% - a premium to the bank, 10% - a fixed bank interest for loans taken for the company). With the swap, the company reduces the financing costs of a fixed-rate loan by 0.5%, and the bank also saves on the financing costs of 0.5% variable-rate debt.

Structure

In an IRS transaction, each counterparty undertakes to pay a fixed or floating rate, denominated in one currency or another, in favor of the other counterparty. Fixed or floating rate multiplied by notional principal(say $1 million). Sharing this notional amount between counterparties, as a rule, is not carried out, it is used only to calculate the amount of interest cash flows to be exchanged.

• A pays a fixed rate to B (BUT receives a floating rate)
• B pays a floating rate in favor of A (B receives a fixed rate).

Consider an IRS transaction in which the party BUT having a loan (to a third party) at a floating rate of LIBOR + 150 (= + 1.50%), undertakes to pay in favor of the party B fixed periodic interest payments at 8.65% ( swap rate) in exchange for periodic interest payments at LIBOR+70 basis points (" bp", \u003d + 0.70 %). That is BUT has an "amount" from which he receives a fixed income on swap rate, but would like to have income at a floating rate, that is, the same as the loan obligations: LIBOR +. She turns to AT for the purpose of concluding an interest rate swap - a transaction in which BUT will receive income from the "amount" at the rate of LIBOR + instead of a fixed rate ( swap rate), a AT will receive income from its amount at a fixed rate instead of floating LIBOR+. Benefit for BUT is that the swap eliminates the discrepancy between the income from the "amount" and the cost of the loan - now they are both linked to the LIBOR rate.

It is worth paying attention to the fact that:

1. there is no exchange of principal between the parties and that
2. interest rates are applied to a "notional" (i.e. imaginary) principal amount.
3. interest payments are not paid in full, but are offset between the parties, after which the netting balance is paid.

(L I B O R + 1 .50%) + 8.65% − (L I B O R + 0.70%) = 9.45% (\displaystyle (LIBOR+1.50\%)+8.65\%-(LIBOR+0 .70\%)=9.45\%), net.

The fixed rate (8.65% in this example) is called swap rate.

Picture: BUT receives a fixed income of 8.65% and pays LIBOR+1.50%. BUT wants to bring both streams to LIBOR+. BUT enters into a swap with AT- “redirects 8.65% income to him” (in reality, not all, but only the “netting” balance - the difference between 8.65% and LIBOR + 0.70%) and “receives LIBOR + 0.70% income”. Since the return on the asset is not explicitly shown in the figure, this can be misleading.

At trade inception, the pricing of the swap is such that the swap has zero present net worth ( N P V = 0 (\displaystyle NPV=0)). If one side is willing to pay 50 bp over the swap rate, the other side must pay about 50 bp over LIBOR to make up for it.

Types

As an over-the-counter instrument, IRS transactions can be entered into on a variety of terms to meet the specific needs of the parties to the transaction.

The most common are exchange transactions:

The parties to a transaction can be in the same currency or in two different currencies. (Deals f i x e d − f o r − f i x e d (\displaystyle fixed-for-fixed) in one currency, as a rule, are not possible, since the entire flow can be predicted from the very beginning of the transaction and it makes no sense for the parties to enter into an IRS contract, since they can immediately mutually settle on known future interest payments).

Fixed-For-Floating, one currency

Side AT

• BUT and
• BUT, indexed by the curve X for a notional amount N for a period of T years.

(in reality, a transfer is made from A to B (or vice versa - depends on whose payment is greater) by the amount of the balance (netting) - the difference in "payments")

For example, you pay a flat rate of 5.32% monthly in exchange for Libor USD 1M also monthly for notional amount$1 million over 3 years.

The party that pays the fixed rate in exchange for the floating rate has a long IRS position. Interest rate swaps are, in fact, a simple exchange of one set of interest payments for another.

Swaps in the same currency are used to exchange

• assets / liabilities with a fixed rate on
• floating rate assets / liabilities and vice versa.

For example, if a company has

1. investment of 10 million USD with a yield of 1M USD Libor + 25bp with monthly fixing and payments

she can contract the IRS

According to him, she will:

1. pay floating USD rate 1M Libor+25 bp
2. receive a flat rate of 5.5%,
   thus fixing a profit of 20 bp.

Fixed-For-Floating, 2 currencies

Side P

• pays (receives) a fixed rate in foreign currency BUT and
• receives (pays) a floating rate in foreign currency B, indexed by the curve X for a notional amount N for a period of T years.

For example, you pay a flat rate of 5.32% quarterly on a notional amount 10 MM USD (\displaystyle (\text(10 MM USD))) in exchange for TIBOR USD 3M (\displaystyle (\text(TIBOR USD 3M))) also quarterly on notional amount 1.2 billion yen over 3 years.

For a non-deliverable swap, the dollar equivalent of yen interest payments will be paid/received in accordance with the USD/JPY rate effective on the fixing date for the interest payment value date. There is no exchange of principal amounts. Payments only occur when:

• fixing date and
• the start date of the swap (if the start date of the swap starts in the distant future relative to the date of the transaction).

Swaps F i x e d − f o r − f l o a t i n g (\displaystyle Fixed-for-floating) in 2 currencies are used for exchange

• assets / liabilities with a fixed rate in one currency per
• assets / liabilities with a floating rate in another currency and vice versa.

For example, if a company

1. It has
   • a loan with a fixed rate of 5.3% for 10 million USD with monthly interest payments and
   • investment of 1.2 billion JPY with a yield of 1M JPY Libor + 50bp with monthly fixing and payments and
2. wants to fix income in US dollars, expecting that
   • JPY 1M Libor will fall or
   • USDJPY will rise (the value of the yen will fall against the dollar)

she can contract f i x e d − f o r − f l o a t i n g (\displaystyle fixed-for-floating) IRS in two currencies, on which it will be:

1. pay floating rate JPY 1M Libor+50bp
2. receive a flat rate of USD 5.6%,
   thus fixing a profit of 30bp on the interest rate and currency position.

Floating-For-Floating, one currency

Side P

• A, indexed by the curve X
• receives (pays) a floating rate in foreign currency A, indexed by the curve Y for a notional amount N for a period of T years.

JPY LIBOR 1M (\displaystyle (\text(JPY LIBOR 1M))) monthly in exchange for JPY TIBOR 1M (\displaystyle (\text(JPY TIBOR 1M))) also monthly for notional amount 1 billion yen over 3 years.

swaps are used to hedge or speculate against the widening or narrowing of the spread between two indices.

For example, if a company

If the company

she can enter into an IRS contract in one currency, in which she will, for example:

1. pay floating rate JPY TIBOR + 30 bps
2. receive floating rate JPY LIBOR + 35 bps,
   thus locking in a 35bp return on the interest rate instead of the current 40bp spread and index risk. The nature of the 5bp difference lies in the cost of the swap, which consists of
   1. market expectations of changes in the spread between indices and
   2. bid/offer of the spread, which is the commission of the swap dealer

F l o a t i n g − f o r − f l o a t i n g (\displaystyle Floating-for-floating) swaps are also used when using the same index, but

• with different interest payment dates or
• using different conventions for defining business days.

These swaps are practically not used by speculators, but they have importance for asset and liability management. An example is the 3M LIBOR swap,

• payable prior non-business day convention, quarterly according to the JAJO rule (i.e., January, April, July, October) on the 30th, against
• FMAN (i.e., February, May, August, November) 28 modified following.

Floating-For-Floating, 2 currencies

Side P

• pays (receives) a floating rate in foreign currency A, indexed by the curve X
• receives (pays) a floating rate in foreign currency B, indexed by the curve Y for a notional amount N at the original FX rate for the term T years.

For example, you pay a floating rate USD LIBOR 1M (\displaystyle (\text(USD LIBOR 1M))) quarterly in the amount of USD 10 million in exchange for JPY TIBOR 3M (\displaystyle (\text(JPY TIBOR 3M))) also monthly for notional amount 1.2 billion yen (at the original FX rate of USD/JPY 120) over 4 years.

To understand this type of swap, consider an American company operating in Japan. To finance its development in Japan, the company needs 10 billion yen. The simplest solution for a company would be to issue bonds in Japan. Since the company may be new to the Japanese market and may not have the required reputation among Japanese investors, issuing bonds can be an expensive option. On top of that, a company may not have

• a proper bond issue insurance program in Japan and
• carry out advanced treasury functions in Japan

To solve these problems, the company can issue bonds in the United States and convert dollars into yen. Although these actions solve the first problems, they create new risks for the company:

• FX risk. If USDJPY rises by the maturity date of the bonds, then when the company converts yen into dollars to pay off the debt on the bonds, it will receive less dollars and, accordingly, incur exchange losses
• Interest risk on USD and JPY. If yen rates fall, then the company's return on investment in Japan may fall - this creates interest rate risk.

Currency risk can be eliminated by hedging using forward FX contracts, but this creates a new risk - the interest rate applied to determine the forward FX rate is fixed, while the return on investment in Japan has a floating structure.

Although there are several other options for hedging currency and interest rate risks, the simplest and most effective way is the conclusion f l o a t i n g − f o r − f l o a t i n g (\displaystyle floating-for-floating) swap in two currencies. In this case, the company raises funds by issuing dollar bonds and swaps them into US dollars.

As a result, she

• receives a floating rate in USD corresponding to its costs of servicing the bonds issued by it and
• pays a floating JPY rate corresponding to her return on yen investments.

Fixed-For-Fixed, 2 currencies

Side P

• pays (receives) a fixed rate in foreign currency A,
• receives (pays) a fixed rate in foreign currency B for a period of T years.

For example, you pay JPY 1.6% on notional amount 1.2 billion yen in exchange for USD 5.36% for the equivalent notional amount$10 million at the original FX rate of 120 USDJPY.

Other variations

Other options are possible, although they are less common. They are mainly intended for perfect hedging bonds, ensuring full compliance of interest payments - on bonds and swaps. These options can give rise to swaps in which the principal is paid in one or more payments, as opposed to conventional swaps, in which there is a simple exchange of interest flows - for example, to hedge coupon strip transactions.

Application

Interest rate swaps are used in a wide variety of investment strategies. They are a popular tool for hedging and financial speculation.

Hedging

Fixing an interest rate under a swap agreement allows you to hedge against falling interest rates.

On the other hand, the counterparty receiving the floating leg will benefit from lower interest rates.

Speculation

Due to the low entry threshold for interest rate swap positions, they are popular with traders who speculate on interest rate movements.

So, instead of opening a full-fledged short position on the underlying asset, for which the price is expected to fall, it is enough for a trader to enter into a swap agreement that fixes the interest rate for the same period.

Pricing

More info en:wiki Rational pricing

The value of a fixed leg is defined as the present value of the fixed interest payments known at the time of the transaction or at any time during its existence.

P V fixed = C × ∑ i = 1 M (P × t i T i × d f i) (\displaystyle PV_(\text(fixed))=C\times \sum _(i=1)^(M)(P\times (\frac (t_(i))(T_(i)))\times df_(i))) where C (\displaystyle C)- swap rate M (\displaystyle M)- number of periods of fixed interest payments, P (\displaystyle P) t i (\displaystyle t_(i)) i (\displaystyle i), T i (\displaystyle T_(i)) d f i (\displaystyle df_(i))- discount factor.

At the beginning of the swap, only the future interest payments on the fixed leg are known. Future LIBOR rates are unknown, so the floating leg is calculated in one of two ways:

• based on the current value of floating interest payments determined at the time of the transaction (as a zero-coupon bond);

In the first method, each flow is discounted using a zero coupon rate. It also uses rate curve data available in the market. Zero-coupon rates are used because they generate only one cash flow - as in our case of calculation. Thus, the interest rate swap is treated as a series of zero-coupon bonds.

In the second method, each floating interest payment is calculated based on the forward interest rates for the respective payment dates. Using these rates results in a series of interest payments.

As a result, the cost of the floating leg of the swap for the FRA method is calculated in the following way:

P V float = ∑ j = 1 N (P × f j × t j T j × d f j) (\displaystyle PV_(\text(float))=\sum _(j=1)^(N)(P\times f_(j )\times (\frac (t_(j))(T_(j)))\times df_(j))) where N (\displaystyle N)- the number of floating interest payments, f j (\displaystyle f_(j))- forward interest rate, P (\displaystyle P)- the nominal amount of the transaction, t j (\displaystyle t_(j))- number of days in the percentage period j (\displaystyle j), T j (\displaystyle T_(j))- the financial base of the currency in accordance with the convention and d f j (\displaystyle df_(j))- discount factor. The discount factor always starts at 1.

The factor is calculated as follows:

d f r r e n t p e r i o d = d f p r e v i o u u u r i o D 1 + f o r d r a p r e v i o u r i o d × y e r a r a c a o n (\ displayStyle (df_ (currentperiod) = (\ frac (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_ (df_soper) PreviousPeriod)\times YearFraction))).

A fixed rate quoted in a swap transaction is a rate that gives the present value of fixed cash flows equal to the present value of floating interest flows calculated on forward interest rates valid on the date of calculation:

C = P V float ∑ i = 1 M (P × t i T i × d f i) (\displaystyle C=(\frac (PV_(\text(float)))(\sum _(i=1)^(M)( P\times (\frac (t_(i))(T_(i)))\times df_(i)))))

At the moment of conclusion of the transaction, none of the parties to the contract has advantages in terms of the value of the swap legs, that is:

P V fixed = P V float (\displaystyle PV_(\text(fixed))=PV_(\text(float)))

Thus, at the time of the conclusion of the transaction, there are no payments between the parties.

During the life of the trade, the same pricing technique is used to value the swap, but since forward rates change over time, the fair value ( P V (\displaystyle PV)) of the swap's floating leg will be different from the fixed fixed leg.

Therefore, the swap will become an obligation on one side and a claim on the other, depending on the direction in which interest rates change.

John C. Hull. Options, Futures and Other Derivatives = Options, Futures and Other Derivatives. - 6th ed. - M.: "Williams", 2007. - S. 1056. - ISBN 0-13-149908-4.