interest rate swap

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.

Example

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).

Tax purposes

Another common use of the swap was to avoid the British stamp tax on short sales. Unlike the SEC in the US, in England only the short sells are taxed, and in order to raise enough money to pay for the exchange, taxed at a fairly high rate. To avoid this tax it is possible to simply swap out a position, paying a small fee to the other counterparty instead of a larger fee to the British exchanges.

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) (2003 10-K page 79). 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), see earlier 10-K's for charts and more information (Investor Relations: Annual Reports & Proxy Statements). (Dec 1999 - Dec 2002 duration gap) , (2003 gap).