Conditions and characteristics of interest rate swaps. Currency interest rate swaps in clear language

An interest rate swap is an agreement between two partners to exchange interest obligations over a specified period of time. Interest rate swaps are used for the following purposes:

1) raising funds at a fixed rate when access to bond markets is impossible. If the company has sufficient creditworthiness, it obtains a loan at a floating rate and then uses a swap to exchange it for a fixed rate. As a result, funds are raised by the company at a fixed percentage;

2) raising funds at a rate lower than that currently prevailing on the bond market or credit market. As a result of the swap, a borrower with high creditworthiness attracts funds at a floating rate lower than what the banks offered him. A borrower with low creditworthiness attracts funds at a fixed rate, which, taking into account his creditworthiness, would hardly be possible at all or would be higher;

3) restructuring a portfolio of liabilities or assets without attracting new funds. In this case, with the help of swaps, the ratio between the shares of liabilities or assets with floating and fixed rates changes.

Most often, an interest rate swap is used to replace a fixed interest rate with a floating one and less often to replace one floating rate with another.

When concluding swap transactions, participants are guided by unified international and national standards and rules. Agreements for each swap agreement are not concluded; the parties sign one agreement, which governs all their further relationships when conducting swap transactions. Swap agreements are concluded over the telephone. It is not necessary that interest payments coincide in time. For example, one party may make payments monthly, the other quarterly. The minimum volume of swap transactions is $5 million CIPL.

There are two types of interest rate swaps: pure and basis.

A pure interest rate swap is an agreement between partners to exchange a fixed-rate interest-bearing obligation for a floating-rate obligation. In this case, the participants in the swap exchange interest payments, and not obligations in full. Payments on swaps are usually made in the amount of the difference between interest rates, and not in the amount of the interest rates themselves.

The amount of debt on which interest payments are made is called the principal amount or face value of the swap. Interest payments are calculated on the basis of specified rates and a certain principal amount. The exchange of interest payments allows each participant in the swap to change the structure of its debt to one that is more suitable for its needs. A pure interest rate swap that exchanges a fixed rate for a floating rate in one currency is also called a “vanilla swap.”

An interest rate swap is not a credit agreement. Each borrower participating in the swap fulfills obligations to its lender, paying both interest and principal. Lenders receive interest payments on the debt without determining whether they are received as a result of the swap or directly from the borrower. As a rule, banks are permanent participants in swaps, acting either as intermediaries or as direct participants in the exchange of interest payments. Acting as an intermediary, banks receive and make payments on the swap to each of the swap participants and isolate the swap participants from each other.

An example of a swap would be an agreement between a commercial bank and a corporation in the United States to exchange interest payments annually for five years based on an amount (the face value of the swap) of $100 million. According to this agreement, the bank agrees to pay the corporation annually 9% of the face value, that is, $9 million. The corporation then annually pays the bank an interest rate on one-year Treasury bills. If in one year the interest rate on the obligations is 6%, the corporation will pay the bank $6 million for that year.

Let's consider the mechanism of operation of an interest rate swap using an example (Fig. 11.1). Company A, rated AAA, issued bonds with a fixed coupon of 10% in the amount of $10 million. In the floating rate obligation market, it has the opportunity to raise funds at a rate of LIBOR + 100 bps.

Rice. 11.1. Payment scheme for interest rate swap

The companies decide to enter into an interest rate swap agreement whereby Company A will pay Company B (and subsequently its lender) a floating interest rate of LIBOR, and Company B will pay A a fixed interest rate of 9.5%.

Let's analyze the interest payments made by companies A and B. A pays a fixed percentage of 10% to bondholders (creditors of the company). From the corporation - participant in the swap, B receives interest payments in the amount of 9.5%, corporation B pays the LIBOR rate.

As a result of the swap transaction, Corporation A pays a floating rate equal to LIBOR + 50 bps, which is 50 bps higher. less than the rate at which it could directly raise funds in the market.

Company B pays the bulk, its credit has fallen, the rate is LIBOR + 150 bp. Company A pays a fixed percentage (9.5%). From company A receives a floating interest rate LIBOR. Company B's final interest payments are fixed at 11%, which is 50 bps. less than the rate of direct attraction of funds on the market.

So, each of the companies participating in the swap was able to change the structure of their interest payments on the debt. B replaced payments at a floating interest rate with fixed payments, and switched to paying a floating rate. In addition, both companies received access to interest rates of 50 bp. There are fewer rates at which investors could directly raise funds on the market. This win

in interest rates is due to the different relative advantages of companies A and B in the fixed and floating rate markets.

Let's consider interest payments on a swap in the case where a bank acts as a financial intermediary in organizing the swap. If in the previous example the swap participants distributed the winnings of 100 bp. equally among themselves, then in this case the share of the winnings falls on the commercial bank, which acts as the organizer of the swap. What is a gain from a transaction for swap participants is income received for financial intermediation in such a transaction for the bank. The swap payment scheme is shown in Fig. 11.2.

Rice. 11.2. Swap payment scheme through the intermediary of a bank

Proceedings of payments at the floating LIBOR rate from A to B occur through the bank. When a fixed interest rate passes through the bank, a positive difference of 0.1% remains in it (9.55% - "9.45% = 0.1%). Multiplied by The principal settlement amount (debt amount) of 0.1% will be the bank's profit from intermediary in this transaction.The payments that are made by companies A, B and the intermediary bank in this swap are shown below.

So, as a result of the swap, companies A and B received access to the desired interest rates (floating and fixed), and these rates were 45 bp. lower rates for directly raising funds on the market. The bank made a profit of 0.1%, or 10 bps. If swap payments are made once a year, the profit received by the bank for this period will be equal to 0.1% of the principal amount, that is, 0.001 10000000 = $10,000.

Today, the financial intermediary's remuneration for conducting a swap ranges from 5 to 10 basis points. Banks enter into separate agreements with each of the swap participants, and these agreements act as separate swaps. The benefits of a swap may vary for different swap participants depending on the market situation. Thus, significant demand for fixed-rate financing leads to an increase in premiums from swaps towards borrowers with high credit ratings.

So, the main goals that swap participants can set are the desire to change the structure of interest payments on the debt, gain access to lower rates and benefit. The desire to replace floating rate payments with fixed interest payments may be driven by expectations of rising interest rates in the market. When interest rates are expected to fall in the market, there is a desire to replace fixed-rate obligations with floating-rate obligations. Borrowers with high credit ratings use swap transactions to leverage their comparative advantage in the fixed rate market and gain a better position in the floating rate market. Borrowers of this class include banks, governments and corporations with a credit rating of ALA, AA.

Industrial corporations with lower credit ratings (BOB and lower) may resort to swap transactions and the replacement of a floating interest rate with a fixed one, since they are unable to raise funds at an acceptable fixed rate in the bond market. Commercial banks turn to the swap market to balance their fixed and floating rate assets and liabilities and thereby reduce interest rate risk, which is one of the main banking risks.

A basis swap is an agreement between participants to exchange a floating interest rate on a debt calculated on one basis for a floating interest rate calculated on another basis. For example, a floating rate based on LIBOR may be exchanged for a commercial paper interest rate. Interest rate exchange payments may also be calculated on the same price basis, but for different price periods. For example, a 6-month LIBOR could be exchanged for a 1-month LIBOR. Floating rates with different price bases and periods can also be exchanged.

Basis swaps are used primarily to transition to the desired repo of financial instruments or to cover floating rate obligations under other swaps. This type of swap is less common than a pure interest rate swap.

Swaps have been used in international financial markets for almost 30 years. In different situations, this derivative security creates confidence in its use and its definitions are interpreted differently in the economic literature (Fig. 8.2).

Swap contracts(from the English Swap - exchange), as a type of derivative financial instruments used in international markets since the early 80s. First currency swap was developed in London in 1979, but was not widely used. Drew attention to this type of derivative financial instruments currency swap contract, which included Salomon Brothers, the World Bank and IBM (1981). It was the high reputation of the participants in this swap that ensured long-term trust in this type of derivatives.

In 1982, a new type of contract appeared - options on futures. These were options on Treasury bond futures. This year the first swaps were also concluded - transactions that were significantly different from other derivatives and which subsequently took a leading place in the derivatives market. Swaps are based on changing a cash flow with one characteristics to a cash flow with other characteristics. One of the first officially mentioned swaps was the issue-related swap in 1982. Deutsche Bank issued 7-year Eurobonds totaling $300 million. In 1991, swap transactions amounted to $4,500 billion, which was half the value of the world's outstanding equities and a third of the value of outstanding bonds. Today, the swaps market has surpassed in volume the markets of all other derivative instruments combined.

Swap transactions are concluded for a period from several years to tens of years in order to eliminate currency or interest rate risk, as well as for arbitrage purposes. Often, financial intermediaries - commercial banks - participate in swap transactions. They act as guarantors of compliance with the terms of the agreement, taking on the risks of non-payment and currency risks. In this case, they become a third party to the agreement and receive a reward.

The main feature of swaps is mutual benefit, when, through exchange transactions, both parties achieve the goal that they have set for themselves. Swap transactions are concluded when potential participants intend to take advantage of opportunities on the other side that they themselves do not have. So, both participants receive benefits from the swap contract, neither of them loses or wins, which makes it possible to reduce the cost of the swap transaction. Swap contracts are relatively inexpensive instruments for hedging risks and for carrying out a transaction the interested party pays a commission of about 1% of the transaction amount.

There are various types of swaps:

simple- a standard swap concluded between two partners does not contain any additional conditions;

shock-absorbing- concluded between two partners, the estimated amount of which decreases evenly as the deadline approaches;

growing- a swap, the expected amount of which increases uniformly;

complex (structured)- a swap in which several parties and several currencies take part;

active- changes the interest rate type of the asset

passive- changes the type of interest rate of the liability;

forward- concluded today, but which will begin after a certain period of time. There are also other types of swaps, but they do not happen as often.

The main role in the swap market is played by interest rate and currency swaps, which in practice are often combined in one transaction.

=> Interest rate swap contract - is an agreement between two counterparties to exchange interest payments on a specified amount in order to establish lower borrowing costs. The contract is concluded on the over-the-counter market between financial and credit institutions for a base amount from which the interest rate is calculated. At the end of the term, the balance is displayed: for one of the participants it is positive, for the second it is negative.

Interest rate swaps used for such goals:

1) raising funds at a fixed rate when access to bond markets is impossible. If the company has sufficient creditworthiness, it obtains a loan at a floating rate and then uses a swap to exchange it for a fixed rate. As a result, funds are raised by the company at a fixed percentage;

2) raising funds at a rate lower than that currently prevailing on the bond or credit market. As a result of the swap, a borrower with high creditworthiness attracts funds at a floating rate lower than what the banks offered him. A borrower with low creditworthiness attracts funds at a fixed rate, which, taking into account his creditworthiness, would hardly be possible at all or would be higher;

3) restructuring of a portfolio of liabilities or assets without raising new funds. In this case, with the help of swaps, the ratio between the shares of liabilities or assets with floating and fixed rates changes.

Most often, an interest rate swap is used to replace a fixed interest rate with a floating one and less often to replace one floating rate with another.

When concluding swap transactions, participants are guided by unified international and national standards and rules. Agreements for each swap agreement are not concluded; the parties sign one agreement, which governs all their further relationships when conducting swap transactions. Swap agreements are concluded over the telephone. It is not necessary that interest payments coincide in time. For example, one party may make payments monthly, the other quarterly. The minimum volume of swap transactions is USD 5 million.

There are two Types of interest rate swap contracts:

1) clear (plain or vanilla) - an agreement between partners to exchange an interest-bearing obligation with a fixed rate for obligations with a floating rate. Payments on swaps are made in the amount of the difference between interest rates, and not in the amount of the interest rates themselves. An interest rate swap is not a credit agreement. Each borrower - participant in the swap fulfills obligations to its lender, paying both interest and principal;

2) basis swaps - transactions between participants to exchange a floating interest rate on a debt, calculated on one basis, for a floating interest rate, calculated on another basis; as a result, the floating rate is exchanged for a floating one, but calculated on the basis of a different base rate.

=> Currency swap or swap with cross exchange rates is an agreement based on the exchange of interest payments and denomination in one currency for interest payments and denomination in another currency.

Since a currency swap involves the purchase and sale of various cash flows in the future, it can be considered a type of forward transaction.

Currency swaps use:

To manage currency and interest rate risks;

Market participants - to gain access to the desired currency at the required rate;

Banks - to balance their currency position;

To use your relative advantage in the market for a particular currency.

Swaps can be viewed as a package of forward contracts, but unlike forward contracts, swaps are longer-term agreements, ranging from 2 to 15 years. Swaps are more liquid than forwards, especially if they are long-term forwards.

Compared to other derivatives, swaps have a number of advantages:

Both parties to the contract have the opportunity to achieve the set goal: hedging risk or reducing the cost of raising funds;

The cost of swaps is significantly lower than the cost of other hedging instruments, such as options, and, in case of mutual agreement, commissions on swap transactions may not be charged at all;

Transactions are concluded on any underlying instrument and period;

The swap market is well developed, and therefore the procedure for concluding swap contracts is easy to implement, the conditions are discussed, as a rule, over the phone;

The ability to exit a swap transaction early in several ways: enter into reverse swaps, when a new contract compensates for the effect of an existing one; when signing an agreement, it is possible to stipulate cases of termination, which allow each of the parties to terminate the contract for a certain fee;

Reducing the risk for this type of transaction, in the event of failure of one of the parties to fulfill the obligations of the other party, the losses of the other party are limited to contractual interest payments or exchange rate differences, and not to the return of the principal amount of the debt.

However, swap contracts have some disadvantages, including the existence of credit risk, albeit small. If the agreement is made subject to an actual exchange of amounts, the risk increases significantly. Since swaps are long-term derivative financial instruments, the level of risk during the life of the contract is constantly changing and requires constant monitoring. To reduce credit risk, third party guarantees, standby letters of credit, collateral or other types of collateral are used. For the same purpose, swap transactions can be concluded with the help of intermediaries, acting as a clearing house and guaranteeing the fulfillment of all terms of the contract.

A new form of swap contracts is swaptions - this is an option on a swap. They give the right to one or both parties to make certain changes or new conditions to the contract during the period of its validity. In general, the swap contract market is currently developing most rapidly and over the past ten years has occupied a leading position in the structure of the financial derivatives market. This is greatly facilitated by the flexibility of these derivatives and the almost unlimited possibilities for constructing new instruments based on swaps.

TO other types of derivative securities relate:

* Security certificate;

If on external stock markets depositary receipts can represent the underlying security, then on internal stock markets this function is performed by a security certificate. Certificate- this is a document certifying a particular fact (for example, a product quality certificate). If a share is a documented investment in the authorized capital of a company, then a share certificate is a documented confirmation of an investment in the authorized capital.

Certificate of shares (bonds) - This is a document certifying ownership of the relevant securities, as well as the right to own and dispose of one or more securities of the same issue (series).

Order, or a subscription certificate that gives its holders the right to purchase (subscribe) additional securities at a certain price at a certain time.

The purpose of the order is to interest potential investors in purchasing shares of new issues. The order is issued together with the underlying security, but may have independent circulation, rate, and other investment characteristics inherent in the securities. Most often, the warrant is issued for a period of one to several years. This is, of course, a registered security. A warrant is different from a warrant or an option certificate. Thus, a warrant gives the right to exchange one security for another; An option gives the right to buy and sell. In the case of an order, we are talking only about a purchase (subscription).

Coupon - this is a tear-off (cut-off) part of a security, giving the right to receive income (interest) and dividends on them within the time limits established in it. Most often, a coupon is an attribute of a bond, which in this case is called a coupon bond. Regardless of whether a coupon is recognized as a security in a given country or not, it must be identified from the main bond. To do this, it must contain: the name of the issuer, the name of the bond, the number of the bond and coupon, the amount and validity period of the coupon, and, if necessary, the name of the paying agent (bank). Other details are also possible. As a rule, coupons are issued to bearer even when the underlying security is registered. The coupon is attached to the bond and is valid along with it. But it can exist outside the main paper as an annex to it. In this case, it can be in circulation, have a rate and can be officially recognized as a security.

TO surrogate forms valuable papers also include:

Lottery tickets, insurance policies;

Mandatory money substitutes (receipts, sales receipts, postage stamps, coupons)

Rekta-papers (will, executory signature of a notary, arbitration or court decision), etc.

Interest rate swaps are agreements to exchange a series of payments. In this case, one party pays a fixed interest, while the other pays a floating interest. Essentially, this process resembles the exchange of a fixed rate security for a floating rate pegged to LIBOR (London interbank offered rate) or Mosprime ( independent indicative rate for providing ruble loans (deposits).

Taking into account the fact that interest rate swaps relate to over-the-counter assets, transactions on them are concluded between organizations such as brokerage companies, banks, and hedge funds.

Interest rate swaps

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

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

These types of agreements can be used for speculative purposes. Profit in this case is obtained from the difference in indicative rates. How it works? Let's say you want to make money on the difference in bets. Yields are expected to rise following a rate hike by the central bank. In this case, it is possible to use, in which payment is made at a fixed percentage. You receive a Mosprime rate and an additional margin. If your calculations turn out to be correct and the rate increases, therefore, Mosprime’s rate will also increase. To take profit, you can make a reverse transaction.

In terms of arbitrage, you can work based on changes in either one or both indicative rates. for the future period can be obtained by combining short-term futures contracts on rates. Naturally, when indicative rates change, the result will also change. Otherwise, you can use an arbitrage operation.

These types of swaps are used mainly in the foreign exchange market. As for their return, it can often be lower than the return on cash assets. True, during arbitrage operations it can be increased.

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The simplest explanations of the nature of 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 believes that they will fall. Let Company A agree to pay Company B an interest rate of 5% per annum on a principal amount of $100 million. In return, Company B agrees to pay Company A six months LIBOR on the same principal rate.
Let's assume that companies exchange payments every six months (for three years), with a 5% rate accrued every six months.

The first exchange of payments took place on January 10, 2009, that is, six months after the agreement was concluded. Company A must pay $2.5 million to Company B. In turn, Company B must pay Company A interest income accrued on $100 million at the six-month LIBOR rate established on 07/10/2008. Let the 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 July 10, 2009. It is known that company A will again pay company B $2.5 million. On January 10, 2009, the established six-month LIBOR rate is 4.8%. This means that Company B will pay Company A $2.4 million.
Table 1 lists all payments and proceeds under the three-year swap for Company A that have allegedly already taken place.

Table 1. Payments and receipts under Company A's three-year swap

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 has had a steady upward trend over the three-year period.

Using a swap to transform liabilities
An example of converting obligations. Let company A borrow $100 million at a rate of LIBOR plus 10 basis points (i.e. LIBOR + 0.1%). Company A analysts came to the conclusion that the LIBOR rate will increase in the next three years.

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

Using 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 it 4.7% per annum. Company B has bonds that bring it a fixed LIBOR interest at a LIBOR rate of 0.2. Companies A and B can use a swap to transform their assets, say, according to this scheme (Fig. 3). In this case, the increase will benefit Company A, and vice versa.


The role of financial intermediaries
Typically, many companies, especially non-financial companies, do not directly negotiate a swap. Each of them communicates with a financial intermediary, who enters into transactions with companies regarding swaps (puts companies into a swap) and receives three or four basis points for their services (ie 0.03 or 0.04%). In this case, the transaction shown in Fig. 2 is converted into the deal shown in Fig. 4.

In this case, the financial intermediary receives a profit of 0.03%, accrued on an 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 at a fixed interest rate, and for companies to issue obligations at a floating rate. As a result of the exchange of these obligations, the parties' costs associated with entering the relevant markets are reduced and the profitability of their operations is increased.
Another common type of swap is a 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 a real exchange of denomination may not occur. The implementation of a currency swap can be due to various reasons:
? currency restrictions on currency conversion;
? desire to eliminate currency risks;
? the desire to issue bonds in the currency of another country in conditions where the foreign issuer is poorly known in this country, and therefore the market for this currency is directly inaccessible to it.

Structure

In an IRS transaction, each counterparty agrees to pay a fixed or floating rate, denominated in one currency or another, to the other counterparty. Fixed or floating rate multiplied by notional principal amount(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 in favor B (A receives a floating rate)
• B pays a floating rate to A (B receives a fixed rate).

Consider an IRS transaction in which a party A, 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 a rate of 8.65% ( swap rate) in exchange for periodic interest payments at the rate of LIBOR+70 basis points (“ bp", =+0.70%). That is A has a “sum” from which it receives a fixed income for swap rate, but would like to have income at a floating rate, that is, the same as the loan obligations: LIBOR+. She turns to IN for the purpose of concluding an interest rate swap - a transaction in which A will receive income from the “amount” at the LIBOR+ rate instead of a fixed rate ( swap rate), A IN will receive income from its amount at a fixed rate instead of the floating LIBOR+. Benefit for A is that the swap eliminates the discrepancy between the income from the "amount" and the expense of the loan - they are now both tied 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 apply to the “notional” (i.e., imaginary) principal amount.
3. interest payments are not paid in full, but are offset between the parties, after which the balance of the offset is paid.

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

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

At the time of the transaction, the pricing of the swap is such that the swap has a zero current net value ( N P V = 0 (\displaystyle NPV=0)). If one party is willing to pay 50 bps over the swap rate, the other party must pay about 50 bps over LIBOR to compensate.

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 exchange transactions are:

The parties to the transaction may be in the same currency or in two different currencies. (Transactions f i x e d − f o r − f i x e d (\displaystyle fixed-for-fixed) in one currency are generally not possible since the entire flow can be predicted from the outset of the transaction and there is no point for the parties to enter into an IRS contract since they can settle immediately for known future interest payments).

Fixed-For-Floating, one currency

Side IN

• A And
• A, 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 - depending on whose payment is greater) by the amount of the balance (netting) - the difference in “payments”)

For example, you pay a fixed 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 a fixed rate in exchange for a variable rate has a long IRS position. Interest rate swaps are essentially a simple exchange of one set of interest payments for another.

Single currency swaps are used for exchange

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

For example, if a company has

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

she can contract with the IRS

According to it it will be:

1. pay a floating rate USD 1M Libor+25 bp
2. receive a fixed rate of 5.5%,
   thereby recording an income of 20 bp.

Fixed-For-Floating, 2 currencies

Side P

• pays (receives) a fixed rate in foreign currency A 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.

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

• the arrival of the fixing date and
• the beginning date of the swap (if the start date of the swap begins 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) 2 currencies are used for exchange

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

For example, if a company

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

she can sign a 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, according to which it will be:

1. pay floating rate JPY 1M Libor+50 bp
2. receive a fixed rate of USD 5.6%,
   thereby recording an income of 30 bp 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 on notional amount 1 billion yen over 3 years.

swaps are used to hedge or speculate against a widening or narrowing 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 a floating rate JPY LIBOR + 35 bps,
   thereby locking in a 35bp return on the interest rate instead of the current 40bp spread and index risk. The nature of the 5 bp 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 spread, which is the swap dealer's commission

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 are important for managing assets and liabilities. An example is the 3M LIBOR swap,

• paid 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 variable 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 on notional amount 1.2 billion yen (at initial FX rate USD/JPY 120) over 4 years.

To understand this type of swap, consider an American company with operations in Japan. To finance its development in Japan, the company requires 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 may be an expensive option. In addition to all that has been said, the company may not have

• an adequate insurance program for bond issues in Japan and
• carry out developed treasury functions in Japan

To solve these problems, a 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 the USDJPY rate 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 fewer dollars and, accordingly, will incur exchange rate losses
• Interest risk on USD and JPY. If yen rates fall, the profitability of a company's investments in Japan may fall - this gives rise to 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 to enter into 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 receives funds by issuing dollar bonds and swaps them in US dollars.

As a result, she

• receives a floating rate in USD corresponding to its expenses for servicing the bonds issued to it and
• pays a floating rate on JPY corresponding to its income on investments in yen.

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% per equivalent notional amount 10 million dollars at the initial FX rate of 120 USDJPY.

Other variations

Other options are possible, although they are less common. They are mainly intended for perfect hedging the bond, ensuring full compliance of interest payments - on the bond and the swap. 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 interest flows are simply exchanged - 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 the 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 when interest rates fall.

Speculation

Due to the low threshold for entering into an interest rate swap position, they are popular with traders speculating on interest rate movements.

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

Pricing

More information 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 the transaction is entered into or at any point in its existence.

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 (like a zero-coupon bond);

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

In the second method, each floating interest payment is calculated based on forward interest rates for the corresponding 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 as follows:

The factor is calculated as follows:

Fixed rate quoted on a swap transaction - a rate that gives the present value of fixed cash flows equal to the present value of floating interest flows, calculated at forward interest rates in effect on the calculation date:

At the time of conclusion of the transaction, none of the parties to the contract has an advantage in the cost of the legs of the swap, that is:

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

Over the life of the trade, the same pricing technique is used to estimate the value of the swap, but as forward rates change over time, the present value ( P V) the floating leg of the swap will be different from the unchanged fixed leg.

Consequently, the swap will become an obligation of one party and a requirement of the other - depending on the direction of changes in interest rates.

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