Interest rate swap

In the field of derivatives, a popular form of swap is the interest rate swap, in which one party exchanges a stream of interest for another party's stream. Interest rate swaps are normally 'fixed against floating', but can also be 'fixed against fixed' or 'floating against floating' rate swaps. Interest rate swaps are often used by companies to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or swapping floating rate obligations to fixed-rate obligations. By swapping interest rates, a company is able to synthethically alter their interest rate exposures and bring them in line with management's appetite for interest rate risk.

Example

Consider the following illustration in which Party A agrees to pay Party B periodic interest rate payments of LIBOR + 50bps (bps = basis points = 0.01%) 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" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. if LIBOR + 50bps is 1.20% then Party A receives 1.80% and pays B nothing). The fixed rate (3.00% in this example) is referred to as the swap rate.

Trading An interest-rate swap is one of the more common forms of over-the-counter derivatives. It is the most widely used derivative in terms of its outstanding notional amount, 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 futures exchange like an option or a futures contract.

Valuation and Pricing

The present value of a plain vanilla (i.e. straightforward) swap can easily be computed using standard methods of determining the present value of the components. The swap requires from one party a series of payments based on variable rates, which are determined at the agreed dates of each payment. At the time the swap is entered into, only the actual payment rates of the fixed leg are known in the future, but an estimation of the future rates of the floating leg are derived from the yield curve: the yield of bonds with various maturity dates stretching from the short term to the long term. Each variable rate payment is calculated based on the forward rate for each respective payment date. Using these interest rates leads to a series of cash flows. Each cash flow is discounted by the zero-coupon rate for the date of the payment; this is also sourced from the yield curve data available from the market. Zero-coupon rates are used because these rates are for bonds which pay only one cash flow. The interest rate swap is therefore treated like a series of zero-coupon bonds.

This calculation leads to a PV. The fixed rate offered in the swap is the rate which values the fixed rates payments at the same PV as the variable rate payments using today's forward rates. Therefore, at the time the contract is entered into, there is no advantage to either party, and therefore the swap requires no upfront payment. During the life of the swap, the same valuation technique is used, but since, over time, the forward rates change, the PV of the variable-rate part of the swap will deviate from the unchangeable fixed-rate side of the swap. Therefore, the swap will be an asset to one party and a liability to the other. The way these changes in value are reported is the subject of Financial Instruments: Recognition and Measurement for jurisdictions following IFRS, and FAS 133 for U.S. GAAP.

Credit Risk

Credit Risk on the swap comes into play if the swap is in the money or not. If one of the party is in the money, then that party faces credit risk of possible default by another party. This is true for all swaps where there is no exchange of principle.

Marking to Market

The current valuation of securities in a portfolio. Debt Security Traders mostly use this in order to visualize their inventory at a certain time.

Users

Fannie Mae

Fannie Mae uses interest rate derivatives to for example "hedge" its cash flow. The products it uses are pay-fixed swaps, receive-fixed swaps, basis swaps, interest rate cap and swaptions, and forward starting swaps. Its "cash flow hedges" had a notional value of $872 billion at December 31, 2003, while its "fair value hedges" stood at $169 billion (SEC Filings) (2003 10-K page 79). Its "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 Fannie Mae doesn'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 inability to pay the bills on liabilities. It reports the duration gap regularly in its (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).