Interest rate swap
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In the field of derivatives trading, a popular form of swap is the interest rate swap, in which one party exchanges a stream of interest for another stream. Interest rate swaps can be fixed-to-floating, fixed-to-fixed or floating-to-floating rate swaps. Interest rate swaps are often used by companies to re-allocate their exposure to interest-rate fluctuations, typically by exchanging fixed-rate obligations for floating rate obligations.
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Example
Swap.JPG
Consider the following illustration in which Party A agrees to pay Party B periodic interest rate payments of LIBOR + 50bps (bps = basis points) in exchange for periodic interest rate payments of 3.00%. Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" principal amount (i.e. imaginary). Also note that the interest payments are settled in net (i.e. if LIBOR is 1.00% then Party A receives 1.50% and pays B nothing).
Trading
An interest-rate swap is one of the more common forms of over-the-counter derivative security transactions. It's probably the most widely used derivative on a notional value basis, but it's not standardized enough and doesn't have the properties to easily change hands in a way that will let it be traded through a securities exchange like an option or a future.
Valuation
The present value of a vanilla swap can easily be computed using standard methods of determining the present value of the components.
Users
Fannie Mae
Fannie Mae use rate swaps to for example "hedge" their cash flow. The products they use are "pay-fixed swaps", "receive-fixed swaps", "basis swaps", "caps and swaptions, "forward starting swaps". Their "cash flow hedges" had a notional value of $872 billion at December 31, 2003, while their "fair value hedges" stood at $169 billion (SEC Filings (http://www.fanniemae.com/ir/sec/index.jhtml?s=SEC+Filings)) (2003 10-K page 79 (http://phx.corporate-ir.net/phoenix.zhtml?c=108360&p=irol-SECText&TEXT=aHR0cDovL2NjYm4uMTBrd2l6YXJkLmNvbS94bWwvZmlsaW5nLnhtbD9yZXBvPXRlbmsmaXBhZ2U9MjY3MDAzNiZkb2M9MSZudW09ODI=)). Their "net value" on "a net present value basis, to settle at current market rates all outstanding derivative contracts" was (7,712) million and 8,139 million, which makes a total of 6,633 million when a "purchased options time value" of 8,139 million is added.
What they don't want is for example a wide "duration gap" for a long period. If rates turn the opposite way on a duration gap the cash flow from assets and liabilities may not match. Resulting in unability to pay the bills on liabilities. They report the duration gap regularly in their (8-K Regulation FD Disclosure (http://finance.yahoo.com/q/sec?s=FNM)), see earlier 10-K's for charts and more information (Investor Relations: Annual Reports & Proxy Statements (http://www.fanniemae.com/ir/annualreport/index.jhtml?s=Annual+Reports+%26+Proxy+Statements)). (Dec 1999 - Dec 2002 duration gap (http://phx.corporate-ir.net/phoenix.zhtml?c=108360&p=irol-SECText&TEXT=aHR0cDovL2NjYm4uMTBrd2l6YXJkLmNvbS94bWwvZmlsaW5nLnhtbD9yZXBvPXRlbmsmaXBhZ2U9MjA4NTc3NSZkb2M9MSZudW09MTk=)) , (2003 gap (http://phx.corporate-ir.net/phoenix.zhtml?c=108360&p=irol-SECText&TEXT=aHR0cDovL2NjYm4uMTBrd2l6YXJkLmNvbS94bWwvZmlsaW5nLnhtbD9yZXBvPXRlbmsmaXBhZ2U9MjY3MDAzNiZkb2M9MSZudW09OTA=)).
References
- Pricing and Hedging Swaps, Miron P. & Swannell P., Euromoney books 1995
See also
- Exotic interest rate option
- Interest rate cap
- Interest rate floor
- Swaption
- Swap (finance)
- Equity swap
- Total return swap
External links
Extensions of swap
- Investopedia - Spreadlock (http://www.investopedia.com/terms/s/spreadlock.asp) - An interest rate swap future (not an option)
- Spreadlock (http://my.dreamwiz.com/stoneq/products/spread.htm) (written by http://my.dreamwiz.com/stoneq/)
Articles
- Hussman Funds - Freight Trains and Steep Curves (http://www.hussmanfunds.com/html/debtswap.htm)
Examples
- GE restate earnings (http://www.ge.com/en/company/investor/webcast/webcast_05062005.htm) because interest rate swaps didin't meet SFAS 133 hedge accounting criteriade:Zinsswap