Interest rate swaps
, Posted in: Interest rate swaps, Author: admin
As we discovered in the earlier posts, an interest rate swap can be created as a combination of currency swaps. Of course, no one would create an interest rate swap that way; doing so would require two transactions when only one would suffice. Interest rate swaps evolved into their own market. In fact, the interest rate swap market is much bigger than the currency swap market, as we have seen in the notional principal statistics.
As previously noted, one way to look at an interest rate swap is that it is a currency swap in which both currencies are the same. Consider a swap to pay Currency A fixed and Currency B floating. Currency A could be dollars, and B could be euros. But what if A and B are both dollars, or A and B are both euros? The first case is a dollar-denominated plain vanilla swap; the second is a euro-denominated plain vanilla swap. A plain vanilla swap is simply an interest rate swap in which one party pays a fixed rate and the other pays a pouting rate, with both sets of payments in the same currency. In fact, the plain vanilla swap is probably the most common derivative transaction in the global financial system.
Note that because we are paying in the same currency, there is no need to exchange notional principals at the beginning and at the end of an interest rate swap. In addition, the interest payments can be, and nearly always are, netted. If one party owes $X and the other owes $Y, the party owing the greater amount pays the net difference, which greatly reduces the credit risk. Finally, we note that there is no reason to have both sides pay a fixed rate. The two streams of payments would be identical in that case. So in an interest rate swap, either one side always pays fixed and the other side pays floating, or both sides paying floating, but never do both sides pay fixed.
Thus, in a plain vanilla interest rate swap, one party makes interest payments at a fixed rate and the other makes interest payments at a floating rate. Both sets of payments are on the same notional principal and occur on regularly scheduled dates. For each payment, the interest rate is multiplied by a fraction representing the number of days in the settlement period over the number of days in a year. In some cases, the settlement period is computed assuming 30 days in each month; in others, an exact day count is used. Some cases assume a 360-day year; others use 365 days.
Let us now illustrate an interest rate swap. Suppose that on 15 December, General Electric Company (NYSE: GE) borrows money for one year from a bank such as Bank of America (NYSE: BAC). The loan is for $25 million and specifies that GE will make interest payments on a quarterly basis on the 15th of March, June, September, and December for one year at the rate of LIBOR plus 25 basis points. At the end of the year, it will pay back the principal. On the 15th of December, March, June, and September, LIBOR is observed and sets the rate for that quarter. The interest is then paid at the end of the quarter.
GE believes that it is getting a good rate, but fearing a rise in interest rates, it would prefer a fixed-rate loan. It can easily convert the floating-rate loan to a fixed-rate loan by engaging in a swap. Suppose it approaches JP Morgan Chase (NYSE: JPM), a large dealer bank, and requests a quote on a swap to pay a fixed rate and receive LIBOR, with payments on the dates of its loan payments. The bank prices the swap and quotes a fixed rate of 6.2 percent. The fixed payments will be made based on a day count of 901365, and the floating payments will be made based on 901360. Current LlBOR is 5.9 percent. Therefore, the first fixed payment, which GE makes to JPM, is $25,000,000(0.062)(90/365)= $382,192. This is also the amount of each remaining fixed payment.
The first floating payment, which JPM makes to GE, is $25,000,000(0.059)(901360)= $368,750. Of course, the remaining floating payments will not be known until later.