Interest rate swap on libor mosprime rate. What is an interest rate swap

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

What is a swap transaction?

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 directions. On a certain date, currency is purchased, and on another date it is reversed - sold. Moreover, this transaction usually implies pre-known conditions for the purchase and sale of currency; they can be either the same or different.

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

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

Currency swap: example transaction

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

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

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

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

Through simple calculations, we find that if the rate rises above 1.417, then in the reverse transaction you will already receive small losses. This is bad, because initially everything was planned only to make a profit. In this case, it is very inappropriate to depend on the exchange rate.

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

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

• The purchase of 1 million dollars is now at an exchange rate of 1.350, that is, for 741 thousand euros.
• I will sell 1 million dollars in a year at the rate of 1.355, that is, for 738 thousand euros.

At the same time, your 50 thousand dollars of profit from the transaction with the purchase of bonds remains in your hands. Converting them into euros will depend on the market rate, but you, as an investor, still remain in the black.

If during this time the exchange rate has increased 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 exchange rate changes to a more favorable one for you, this will mean that you could earn more. However, the risks you would have to take are not worth it.

As we can see, a foreign currency swap transaction gives the investor confidence that his investment will be justified and will not cause losses when exchanging currencies. In this situation, both parties benefit, 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 away 1 million dollars at one rate, and then buy them back at a rate already known in advance and make a profit of 3 thousand euros. And at the same time, he will remain with his money, will not lose anything and does not risk anything.

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 from both one side and 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 more clear what this is, consider 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 a Russian bank, which, for example, can borrow francs at a more favorable 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 out the loans described above and exchange currencies, paying a certain percentage. After the expiration of the concluded agreement, banks make a reverse transaction.

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

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

Let's sum it up

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

In this case, one party receives confidence in receiving a fixed profit, and the other receives a guarantee of a constant exchange rate in case of reverse currency exchange. Moreover, this rate (both purchase and sale) 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 the specific rate before the exchange takes place. You know in advance how much you will pay for a certain amount, and how much you will receive for it later. The bank, in turn, knows in advance what profit it will receive. Both sides do not take risks and are not affected by exchange rate fluctuations.

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 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 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.

Id=".D0.A1.D1.82.D1.80.D1.83.D0.BA.D1.82.D1.83.D1.80.D0.B0">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.

Side A currently pays a variable rate but wants to pay a fixed rate. B currently pays a fixed rate, but wants to pay a variable rate.
Upon conclusion of the IRS transaction, the net result is that the parties may " exchange» your current interest obligations to your desired interest obligations.

The most generally accepted by the IRS is a transaction in which one counterparty (the counterparty A) pays a fixed rate (swap transaction rate) in favor of the counterparty B, receiving in return a floating rate (usually linked to a base rate, such as LIBOR or MOSPRIME).

• 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[ | ]

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.

An interest rate swap is an agreement between parties to make a series of payments to each other on agreed dates before the expiration of the agreement. The amount of interest payments of each party is calculated based on different formulas, based on principal amount specified in the swap agreement.

In interest rate swaps the principal amount rarely passes from counterparty to counterparty - it is used only as reference point to calculate the amount of payments. This means that the parties change the interest payment bases on the debt or investment without changing the principal amount of the loan or investment. Interest payment is made in the same currency.

Example of a simple interest rate swap

This example considers the exchange of interest payment for fixed rate for interest payment on floating rate.

An enterprise with a BBB credit rating needs a loan (credit) of $50 million for 5 years with fixed interest rate. This rate allows you to plan the future cost of financing - allows the company to hedge interest rate risk.

An international bank with a credit rating of AAA needs a loan (credit) of $50 million for 5 years with a floating interest rate. This rate allows the Bank to manage the profit margin in the event of a discrepancy between the levels of interest rates on assets and liabilities - it allows the Bank to hedge the interest rate risk.

Table 1. Classification of foreign exchange market instruments.

The enterprise and the Bank enter into a swap agreement, which allows them to reduce interest payments. In this case, there will be no exchange of the main amounts; $50 million will appear as conditional The principal amount on which interest will accrue.

The enterprise and the Bank receive a loan on terms available to them, and then exchange interest payments. The company receives a loan with a floating rate of LIBOR +1%, and the Bank receives a loan with a fixed rate of 8.25%. Thus, the two entities enter into a 5-year fixed/floating rate swap.

Rice. 1. Payment exchange scheme.

In practice, only one payment is made when the due date arrives. Only the net difference between payments in the relevant currency is paid. For this reason, interest rate swaps are often called transactions for difference.

As a result of the exchange of interest payments, the net payments of both parties are lower than in any other case. Interest rate swaps work as follows.

• The company receives a loan at a floating rate of LIBOR + 1%
• The bank receives a loan at a fixed rate of 8.25%
• The Enterprise and the Bank enter into an interest rate swap with a notional principal amount of $50 million for a period of 5 years, under which:
  • The company will make payments at a fixed rate of 9.75% in favor of the Bank
  • The Bank will make payments at a floating rate of LIBOR + 1% in favor of the Enterprise

The entity pays the Bank a higher fixed rate as compensation for its participation in the swap.

Rice. 2. Scheme of exchange of payments and interest payments to Creditors.

Table 2. Benefits received by the Enterprise and the Bank from a five-year swap.

Conclusion from Table 2:

• - without swap, the Enterprise and the Bank pay 10.00% + LIBOR
• - with a swap, parties pay 9.25% + LIBOR

By using the swap, there is a net saving of 0.75%, which is distributed as 0.25% to 0.50% to the bank because it is the institution with a higher credit rating.

Features of interest rate swaps

An interest rate swap is an exchange of interest payments, the amount of which is determined using different formulas based on notional principal amount agreements.

The swap does not involve the exchange of principal amounts - the participants in the swap do not lend to each other.

Counter interest payments are offset, and only the difference between them is paid.

The swap has no effect on the underlying loan or deposit. A swap is an independent transaction.

Consider a company with liabilities equal to $300 million and due in exactly 5 years. The interest rate on the loan is reviewed every 3 months (July 30, September 30, January 30, April 30) and is set on the basis of a 6-month rate +120 basis points. The company's financial director is worried that high inflation will raise the key rate and the cost of funding will increase. Additional costs from the loan will need to be passed on to customers by raising product prices, which will reduce the company's competitiveness. If the director decides not to pass on costs to customers, the company's profitability will fall and have a negative impact on the company's share price.

Agreement percentage swap

The finance director enters into an interest rate swap agreement with a trader from the bank's brokerage department. The terms of the agreement are reflected in the table.

Table. Conditions agreement

The company will make payments at an annual rate of 1.82% on a face value of $300 million every quarter for five years. In exchange, the trader agrees to make payments based on 3-month LIBOR every quarter for five years. The LIBOR rate for a future period is the spot value at the payment date for the past period. To reduce credit risk, one of the parties will pay the difference between the amounts of payments.

Read more about the LIBOR rate in the article.

The transaction date is considered to be July 28, 2014. However, the swap contract comes into effect only from July 30, 2014, i.e., interest on the swap begins to accrue only from July 30. The LIBOR rate for the first period is known in advance: it is 0.23%.

Payment 1: October 30, 2014

The first payment is made for the period from July 30 to October 30, 2014. The company must pay:

$300 million x 0.0182/4 = $1.36 million

The trader's payment is:

$300 million x 0.0023/4 = $173 thousand

Therefore, since the company’s payment is higher, the company must transfer $1.36 million – $0.173 million = $1.187 million to the trader’s account.

Payment 2: January 30, 2015

The second payment is made for the period from October 30, 2014 to January 30, 2015. The company still must pay $1.36 million, which is required for the next trader payment settlement, set at October 30, 2014. Let's say that on October 30, 2014, LIBOR was 45 basis points. Therefore, the trader’s obligation to the company will be:

$300 million x 0.0045/4 = $338 thousand

Thus, on January 30, 2015, the company will be obliged to pay the trader the difference between payments, which is:

$1.36 million – $0.338 million = $1.022 million.

The floating LIBOR rate for the next payment will be reset on January 30, 2015.

Swap payments and

Due to the fact that it involves the exchange of payments four times a year, and its validity period lasts 5 years, the counterparties will exchange payments 20 times. The last payment falls on July 30, 2015. Companies that hedge interest rate risk with swaps typically match the payment dates of the swap with the interest payment dates of the loan.

In the example considered, the first two payments were made from the company to the trader. This situation is typical for the normal form, i.e. the curve has a positive slope, indicating that interest rates are expected to rise. The influx of funds to the trader serves as a kind of safety net for the trader in the event of a rapid rise in rates.

The profitability of the concluded transaction for the two parties will depend on the actual movement of the rate during the validity of the swap contract. If the LIBOR rate rises faster than market expectations, the company will be profitable. Otherwise, the company may suffer a loss from the transaction.