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Interest Rate swaps


  • In the case of fixed-for-floating interest rate swaps two parties get into an agreement where one pays interest on a floating rate to the other, while the other pays a fixed rate of interest on the same amount
  • LIBOR is the most common reference rate of floating interest
  • Notional principal is exchanged or basically no principal is exchanged

  • IRS can be used for
    • Changing a liability
    • Transforming a liability

Changing a liability


  • Party 1 avails a loan of 10% while party 2 avails a floating rate loan at LIBOR +0.3%
  • Party 1 is receiving a fixed rate of 8% from party 2
  • Party 1 pays floating interest rate
    • Party 1’s effective cash flow:
      • Net cash outflow is (LIBOR + 2% )
    • Party 2’s effective cash flow:
      • Net cash outflow is 8.3 %
  • Point to note here is that Party 1’s fixed liability is changed to floating liability after the swap.
  • Party 2’s liability is changed from a floating liability to a fixed liability of 8.3%

Financial intermediaries

  • In the practical world most swaps are traded in the OTC market where financial institutions act as market makers


  • In the diagram above you can see that the financial institution is making a 3 basis point spread on the fixed payment of the transaction
  • In such cases the bank has separate contract with party 1 and party 2
  • Party 1 and party 2 might not even know that they are on the other sides of the same swap
  • Bank creates a market by creating both bid and offer positions so that it can seek clients on either side of the swap
  • It is exposed to certain credit risks in case it is unable to find a counter party for a swap

Swap rates

  • The swap rate is the average of:
    • The fixed rate a market maker is prepared to pay in exchange for a receiving LIBOR (its bid rate)
    • The fixed rate it is willing to receive in return for a payment of a floating rate (its offer rate)
  • Like LIBOR swap rates are not risk free rates but close to risk free rates

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