Interest Rate Swap
Content
Definition of 'Interest Rate Swap'
An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.
Swap (transactions) -- A kind of financial transaction which has many variations, usually highly complex. They
generally involve a simultaneous exchange of assets (the swap) by counterparties for other different assets of comparable value. The assets may be commodities or they may be financial instruments involving interest rates , cash flows , foreign exchange , debts or equities. In addition to financial profits, the swaps have many purposes such as limiting risks, overcoming restrictions in certain markets, or balancing portfolios.
Investopedia explains 'Interest Rate Swap'
Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate specifications) for another. Because they trade OTC, they are really just contracts set up between two or more parties, and thus can be customized in any number of ways.
Interest Rate Swap (IRS)An Interest Rate Swap allows a corporate to hedge the interest rate risks arising on account of lending and borrowings made at fixed or floating rates. There is no exchange of principal amount and the interest payments are calculated only on notional principal amounts. In an IRS the corporate enters into a contract with the bank to exchange a stream of interest payments for a notional principal amount on multiple occasions during a specified period. The contract usually involves exchange of a fixed to floating or floating to floating rates of interest between the company and the bank. Accordingly, cash payments are made, either by the bank or the company on each payment date based on the difference between the fixed/floating or floating/floating rates as the case may be. The floating benchmark rates are normally the NSE Mibor / Reuters Mibor or the appropriate T-Bill yield. Terminology • Trade date : Date when the counter-parties agree on swap conditions • Effective date : Date when the interest obligations start to accrue • Maturity date : Date when the swap terminates
Settlements
A) Fixed rate > Floating rate On fixing date, 3m Mibor is say 5.00% Hence, floating rate is (5.00+1.00) = 6.00% On effective date, Customer Pays IndusInd Bank (6.00%-5.00%)= 1.00% B) Fixed rate < Floating rate On fixing date, 3m Mibor is say 7.00% Hence, floating rate is (7.00+1.00) = 8.00%
On effective date, IndusInd Bank Pays Customer (8.00%-7.00%)= 1.00%
Regulations
While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into IRS only for the purpose of hedging the interest rate risk on the underlying asset/liability.
Currency Swap-A currency swap involves two principal amounts, one for each currency. There is an exchange
of the principal amounts and the rate generally used to determine the two principal amounts is the then prevailing spot rate. Alternatively, the parties to the swap transaction can also enter into delayed/forward start swaps by agreeing to use the forward rate. A currency swap is similar to a series of foreign exchange forward contracts, which are agreements to exchange two streams of cash flows in different currencies. Like all forward contracts, the currency swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency and the swap leg the party agrees to receive is an asset in the other currency. Consider a case of a corporate having a long term borrowing in USD. He can enter into following types of currency swaps to hedge the risks: Types of currency swaps • Hedge both his principal & interest payments • Hedge the principal payments only • Hedge the interest payment only The first mentioned swap is generally the preferred swap. In the stated case, the customer enters into the swap with the bank to receive floating interest rate (USD Libor) payments and USD principal and simultaneously pays INR fixed interest rate and equivalent INR principal amount arrived at based on the spot rate prevailing on the transaction date.
Regulations
While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into Currency Swaps only for the purpose of hedging the interest rate risk on the underlying asset/liability.
An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.
Swap (transactions) -- A kind of financial transaction which has many variations, usually highly complex. They
generally involve a simultaneous exchange of assets (the swap) by counterparties for other different assets of comparable value. The assets may be commodities or they may be financial instruments involving interest rates , cash flows , foreign exchange , debts or equities. In addition to financial profits, the swaps have many purposes such as limiting risks, overcoming restrictions in certain markets, or balancing portfolios.
Investopedia explains 'Interest Rate Swap'
Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate specifications) for another. Because they trade OTC, they are really just contracts set up between two or more parties, and thus can be customized in any number of ways.
Interest Rate Swap (IRS)An Interest Rate Swap allows a corporate to hedge the interest rate risks arising on account of lending and borrowings made at fixed or floating rates. There is no exchange of principal amount and the interest payments are calculated only on notional principal amounts. In an IRS the corporate enters into a contract with the bank to exchange a stream of interest payments for a notional principal amount on multiple occasions during a specified period. The contract usually involves exchange of a fixed to floating or floating to floating rates of interest between the company and the bank. Accordingly, cash payments are made, either by the bank or the company on each payment date based on the difference between the fixed/floating or floating/floating rates as the case may be. The floating benchmark rates are normally the NSE Mibor / Reuters Mibor or the appropriate T-Bill yield. Terminology • Trade date : Date when the counter-parties agree on swap conditions • Effective date : Date when the interest obligations start to accrue • Maturity date : Date when the swap terminates
Settlements
A) Fixed rate > Floating rate On fixing date, 3m Mibor is say 5.00% Hence, floating rate is (5.00+1.00) = 6.00% On effective date, Customer Pays IndusInd Bank (6.00%-5.00%)= 1.00% B) Fixed rate < Floating rate On fixing date, 3m Mibor is say 7.00% Hence, floating rate is (7.00+1.00) = 8.00%
On effective date, IndusInd Bank Pays Customer (8.00%-7.00%)= 1.00%
Regulations
While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into IRS only for the purpose of hedging the interest rate risk on the underlying asset/liability.
Currency Swap-A currency swap involves two principal amounts, one for each currency. There is an exchange
of the principal amounts and the rate generally used to determine the two principal amounts is the then prevailing spot rate. Alternatively, the parties to the swap transaction can also enter into delayed/forward start swaps by agreeing to use the forward rate. A currency swap is similar to a series of foreign exchange forward contracts, which are agreements to exchange two streams of cash flows in different currencies. Like all forward contracts, the currency swap exposes the user to foreign exchange risk. The swap leg the party agrees to pay is a liability in one currency and the swap leg the party agrees to receive is an asset in the other currency. Consider a case of a corporate having a long term borrowing in USD. He can enter into following types of currency swaps to hedge the risks: Types of currency swaps • Hedge both his principal & interest payments • Hedge the principal payments only • Hedge the interest payment only The first mentioned swap is generally the preferred swap. In the stated case, the customer enters into the swap with the bank to receive floating interest rate (USD Libor) payments and USD principal and simultaneously pays INR fixed interest rate and equivalent INR principal amount arrived at based on the spot rate prevailing on the transaction date.
Regulations
While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into Currency Swaps only for the purpose of hedging the interest rate risk on the underlying asset/liability.
