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Though there are several types of interest rate swaps (IRS), the most familiar type is known as fixed-for-floating. A notional amount of principle is used to calculate periodic fixed and floating interest payments. One of the counterparties receives fixed interest payments and pays out floating-rate interest to the other counterparty, who reciprocates by paying fixed and receiving floating. The floating rate can be pegged to three-month the U.S. Treasury bills, London Interbank Offer Rate (LIBOR), or any other well-established rate index.

Illustration

Company A has issued $100 million of floating rate debt pegged to LIBOR rates, meaning it will have to make semi-annual interest payments of an indeterminate amount until the debt matures. At each six-month payment date, Company A pays to creditors half of $100 million times the then-current LIBOR rate. However, Company A is of the opinion that interest rates are about to rise, whereas Company B predicts a rate decrease. Company B agrees to pay floating to and received fixed from Company A based on a $100 million notional amount. Both companies expect to make a gain on the IRS; the company with the correct rate forecast will be the winner.

IRS Pricing

The price of an IRS is the sum of the cash flows discounted by an appropriate factor, such as the Treasury zero-coupon rate at the time of the pricing. By definition, the initial swap price is zero, since the current fixed and floating rates are equal and exactly offset each other. Over time, floating rates will change: if they go up, value accrues to the receiver of floating. Conversely, the receiver of fixed will benefit from a rate decline. As rates change and the discounted cash flows no longer cancel each other out, the IRS price — the difference between the two discounted cash flows – becomes a positive number.

Credit Risk

Credit risk is the risk of a defaulted credit payment. An IRS is subject to a lesser degree of credit risk than a comparable transaction in which the principle amount is actually transferred. The $100 million notional principle in our example is not “real” – it is not exchanged or paid, but simply used as the basis for calculating interest payments. Furthermore, the fixed and floating payments are netted together, and only the difference is forwarded to the appropriate counterparty. Since this netted amount will always be small compared to the notional amount, credit risk is minimized.

Swap Termination

If a swap terminates at its normal maturity date, there are no further cash flows and therefore the swap has a price of zero. If one of the counterparties decides to terminate the IRS before its term is up, the price of the swap at the time of the early termination will have to be exchanged. If interest rates have risen, the fixed counterparty makes payment to the floating, i.e. the floating counterparty is the winner. The reverse is true for falling interest rates. The amount exchanged is the net present value of the remaining netted cash flows. Should a losing counterparty choose to terminate an IRS by selling it to a third party, that counterparty will have to pay the third party the price, if any, of the swap on the date of sale.