An Interest Rate Swap is a contractual agreement between two parties (often referred to as “counterparties”). The counterparties agree to exchange payments based on a defined principal amount, for a fixed period of time.
In an interest rate swap, the principal amount is not actually exchanged between the counterparties, rather, interest payments are exchanged based on a “notional amount” or “notional principal”.
Each counterparty agrees to pay either a “fixed” or “floating” rate to the other counterparty. As mentioned above the notional amount is not exchanged between counterparties, but is used only for calculating the size of the cashflows to be exchanged.
The most common interest rate swap is one where one counterparty pays a fixed rate (the swap rate) while receiving a floating rate (usually based on LIBOR).
The fixed leg of the swap is typically the only leg which is sensitive to changes in interest rates as it can be considered as a fixed rate bond, the offsetting floating leg is typically insensitive to changes in interest rates as the rate refixes regularly throughout the life of the swap.
Market Size
The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC (“Over The Counter”) derivative market. The notional amount outstanding as of December in OTC interest rate swaps was estimated to be $230 trillion. These contracts account for 55% of the entire $415 trillion OTC derivative market.
Key Terms
Notional Amount
This is the principal amount of the swap. It is not exchanged between counterparties and is used for calculating the interest amounts.
Fixed Leg
One counterparty pays a fixed rate throughout the term of the swap agreement, this rate never changes. This counterparty is known as the Fixed Rate Payer.
Floating Leg
One counterparty pays a floating rate throughout the term of the swap agreement which may be monthly, quarterly, semi-annually or annually depending on the interest-rate index of the swap. For example the floating rate on a swap indexed to the three-month Libor would normally reset every three months with payment dates following three months later.
Day Count Convention
This lays down the methodology on how the interest payments are to be calculates eg 30/360 or A/365. (Note: see Fixed Income Course for further detail).
Trade Date
The day the swap agreement was actually negotiated/traded.
Settlement Date
The date that the swap takes effect, normally two days after the trade date.
Effective Date
This is the date that interest begins accruing and normally coincides with the Settlement Date.
Termination Date
The date on which the swap ends and will be the last date that interest payments are exchanged. This is an important piece of data when calculating the value of a swap.
Payment Netting
When the fixed and floating payments occur on the same date it is normal that the two amounts are netted and whichever counterparty owes the difference pays that amount to the other counterparty.
Uses
Interest Rate Swaps are generally used to hedge against or speculate on changes in interest rates.
Hedging
Interest Rate Swaps swaps are often used by funds to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line with management’s appetite for interest rate risk.
They are commonly used by debt issuers to convert their interest payments, for example a corporation which issues floating rate bonds may wish instead to pay a fixed rate to enable financial planning.
Speculation
Interest Rate Swaps are used speculatively by hedge funds who expect a change in interest rates or the relationships between them. Traditionally, fixed income funds who expected rates to fall would purchases cash bonds, whose value increased as rates fell. Today these funds with a similar view could enter a floating-for-fixed interest rate swap: as rates fall, the funds would pay a lower floating rate in exchange for the same fixed rate.
Leverage
Interest Rate Swaps enable hedge funds to leverage their exposure. If they want exposure to a particular rate of interest/issue (eg US 10 Year Treasury Note), they can enter into a swap were they would receive a fixed rate the same as the current 10 year note in issue and pay floating. All without having to allocate any cash.
A similar result can be obtained by entering into a repurchase agreement, whereby the fund would buy the 10 year-note and finance this by entering into a repurchase agreement (repo). What in effect happens is the repo counterparty lends the fund the cash to purchase the bond and the bond is pledges as security against the loan at short-term interest rates . However normally the repo counterparty wont lend the full amount, they may lend 95% (this is none as a repo haircut (5% in this case). So the fund is still required to put up 5% of the value of the bond as cash, hence the swap may be a better alternative.
Accounting and Valuation
Interest Payment Calculations
Take the following example:
Notional: 50,000,000
Fixed Rate Payer: Counterparty
Fixed Rate: 5%
Fixed Rate Payment Frequency: Semi-Annual
Floating Rate Payer: Hedge Fund X
Floating Rate: 3 Month Libor + 10 bps
Floating Rate Payment Frequency: Quarterly
Day Count Convention: A/365
Trade Date: March 30th, 2007
Effective Date: April 1st, 2007
Termination Date: March 31st, 2017
Libor rate at April 1st: 4.75%
Libor rate at July 1st: 5.25%
What would the payments be on both June 30th and September 30th.
On June 30th, only the Floating Rate Payer makes a payment (Fixed Rate Payer is semi-annual). Payment is $606,250 from Hedge Fund X to the counterparty.
This is calculated as follows:
Interest rate is 4.85% (Libor
Days in period is 91 (30+31+30)
50,000,000*4.85% = $2,425,000*91/365 = $606,250
On September 30th:
Fixed Rate Payment is: 50,000,000*5% = $2,500,000*183/365 = $1,275,000
Floating Payment is: 50,000,000*5.35% = $2,675,000*92/365 = $695,500
These amount will be netted ($1,275,000 - $695,500) so the Counterparty pays Hedge Fund X $579,500.
Valuation
The basic premise to an interest rate swap is that the counterparty choosing to pay the fixed rate and the counterparty choosing to pay the floating rate each assume they will gain some advantage in doing so, depending on the interest rate. Their assumptions will be based on their needs and their estimates of the level and changes in interest rates during the period of a swap contract.
A rule of thumb is that if interest rates rise then the Fixed Rate Payer is making money on the swap, if rates fall it loses money. Conversely for the Floating Rate Payer if rates fall it makes money, if rates rise it loses money.
Because an interest rate swap is just a series of cash flows occurring at known future dates, it can be valued by simply summing the present value of each of these cash flows. The value of the fixed leg is given by the present value of the fixed coupon payments known at the start of a swap. Similarly, the value of the floating leg is given by the present value of the floating coupon payments determined at agreed dates of each payment. However, at the start of the swap, only the actual payment rates of the fixed leg are known in the future, we need to use forward rates of interest (based on the swap yield curve) to calculate the cash flows on the floating leg for each respective payment date.
At the inception of the swap the present value of both the fixed and floating legs should be the same.
Bloomberg has a function that will calculate the value of a swap for you (SWPM). A screen will pop up in which you must enter all the relevant details, fixed rate, payment dates, termination date etc. Once the data is entered it will calculate the value of the swap.
Termination Payments
At a point in time before the term of the swap expires both parties may agree to terminate the swap. At that point interest payments are calculated and swapped. In addition the mark-to-market of the swap is calculated and the party that is ‘Out of the Money’ must reimburse the other counterparty by way of a termination payment.
US GAAP Requirements
For accounting purposes there are three elements to each swap, the unrealized mark-to-market (Valuation), interest income and interest expense depending on what party you are to the swap.
US GAAP requires that each of these elements be disclosed in separate line items of the financial statements. In the Statement of Operations the mark-to-market gain/loss will appear under ‘Unrealized Gains/Losses on Derivatives’. Termination Payments would be included under ‘Realized Gains/Losses on Derivatives’. While interest income and expense will appear under those headings. On the Statement of Assets and Liabilities the mark-to-market will appear under either ‘Unrealized Gains on Swap Contracts’ or ‘Unrealized Losses on Swap Contracts’. Accrued interest must be broken out between ‘Accrued Interest Payable’ and ‘Accrued Interest Receivable’.
Other Points
Interest Rate Swaps
The Interest Rate Swaps that we have discussed in this course are what is known as “Vanilla” interest rate swaps. However Interest Rate Swaps can be fixed-for-fixed, fixed-for-floating or floating-for-floating. A floating-for-floating is known as a “Basis Swap”. The legs of the swap can be in the same currency or in different currencies. A single-currency fixed-for-fixed would be in different currencies as the same currency would make no sense.
ISDA
The International Swaps and Derivatives Association (normally known as ISDA) was set up in 1992 to establish a legal framework for contracts such as Interest Rate Swaps. Normally the counterparty to the swap will draft a formal agreement, laid out under ISDA regulations, which will specify the parameters and specifics of each swap. As administrators it is essential that we receive a copy of this agreement for each swap.
The ISDA agreement will normally allow for and lay out the terms by which the hedge fund must post collateral against each swap. This would normally be for the unrealized portion of each swap. In practice there will be a “Master netting Agreement” in place which will allow all swaps with a single counterparty to be aggregated for collateral purposes so that only one amount is posted at any given time.
Interaction with Fixed Income Live one to one Training Course
This course should be read in conjunction with the “Fixed Income” course in relation to accruing interest based on the different Day Count Accrual conventions and Fixed income instruments.
Learn the key features on a FWC
Explain why an investor would trade a FWC
Understand the full cycle of a FWC
o Initiating trade – Open a contract
o Month end valuation
o Liquidating trade – Close a contract
o Take delivery
A forward contract (FWC) can be defined as an agreement to buy or sell an asset (usually a currency) at a future date for a specified price. It is considered to be a “derivative” financial instrument. The characteristics of a forward contract are:
FWC’s are not traded for cash initially. The investor enters into a contract. For accounting purposes, forward contracts are regarded as “off balance sheet” items, meaning that only unrealized gains/losses will be included on the balance sheet and not the cost.
The underlying bet is usually on a currency.
FWC’s are contract are traded “over-the-counter” (OTC) which means they are not traded on a regular exchange. They are essentially private deals arranged by your broker. However, despite trading OTC, forward contracts are very liquid, meaning they trade with very high volume.
The cash settlement of a contract takes place on the maturity date of the contract rather than at the time of the closing trade.
If you sold a FWC on 08/14/06 for a profit, you would not receive your money until the maturity date of the actual contract. The realized P/L would be recognized on 08/14/06 and a receivable would impact on your balance sheet. Then on maturity date, cash would be received and your receivable would be closed.
Alternatively, if you did not close the contract before the maturity date, you have chosen to “take delivery” of the currency at the exchange rate agreed in the opening trade(s).
The maturity date is also known as the settlement date or end date.
Hedge funds trade forward contracts for three reasons
1. To hedge foreign currency risk in their portfolios
2. For speculative purposes
3. To hedge foreign currency risk in share classes.
Hedge funds commonly hold many securities in many different currencies. They need to be concerned with the fluctuation of currency rates because their NAV is ultimately issued in the base currency of the fund, meaning that all holdings need to be translated into base currency when a NAV is produced.
Let’s say you have a USD fund that wants to invest in a EUR security.
The purchase can be funded in one of two ways
1. Borrow EUR to purchase the EUR security, thereby holding a long position in the EUR security and being short EUR cash.
2. Enter a spot selling USD and buying EUR and use the EUR to purchase the security. This method leaves the fund exposed to EUR/USD currency risk. For example, the EUR security price could increase while the EUR/USD exchange rate weakens, resulting in a loss to the fund overall. To avoid this currency exposure the fund would enter into a forward hedge selling EUR and buying USD.
Let’s look at an example: A fund holds 10,000,000 worth of EUR denominated common stock. When they purchased the shares three months ago, that 10,000,000 EUR were worth 12,875,000 USD. However today that same 10,000,000 EUR might be worth only 12,750,000 USD. Even if the value of your shares in EUR may not have changed, you have lost 125,000 USD worth of your portfolio in USD. For this reason a fund would typically enter a FWC agreeing to SELL 10,000,000 EUR fearing the EUR would drop in value as in this case. The profit earned on the FWC would offset the loss described.
A hedge fund may trade currencies as an asset class. A hedge fund may wish to speculate in a currency the same way they speculate in anything else; buy low and sell high. They PURCHASE the currency if they feel it will strengthen and they SELL it if they think it will weaken. Examples are FX Spot, FX Forward and FX Option
This is beyond the scope of the current module
Let’s look at an example. The fund believes the HKD will fall against the USD within the next few months. On 05/17/06, they will transact a sell order for 10,000,000 HKD with a maturity date of 08/30/06 against an amount of 1,291,900 USD.
Each NAV date, this HKD 08/30/06 FWC is priced using Bloomberg forward rates for HKD/USD and the unrealized P/L is recorded on your balance sheet and income statement. The unrealized P/L arises from any movement in HKD/USD rates from that agreed in the contract.
On 07/13/06, the fund decides to close the entire HKD contract by purchasing 10,000,000 HKD against 1,288,000 USD. This would result in a gain of 3,900 USD. The realized P/L of 3,900 USD would be recognized as of the closing trade date of 07/13/06. Also a receivable would impact your balance sheet at the same time. Your position of HKD 08/30/06 would be zero.
The realized P/L occurs because of the movement in the USD/HKD rate from 0.12919 to 0.1288
Finally on 08/30/06, cash for 3,900 USD would come into your broker statement. This cash would relieve your receivable on your balance sheet from 07/13/06.
Let’s look at the same example above but without the closing entry on 07/13/06. What would happen in this case?
Each NAV date, this HKD 08/30/06 FWC is priced and the unrealized P/L is recorded on your balance sheet and income statement.
On 08/30/06, cash for the original amounts flow through your broker statement as follows:
i) 10,000,000 HKD would go out of your HKD broker statement (the fund sold HKD)
ii) 1,291,900 USD would come into your USD broker statement
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