Floating-rate payer

While our illustrations assume that the timing of the cash flows for both the fixed-rate payer and floating-rate payer will be the same, this is rarely the case in a swap. An agreement may call for the fixed-rate payer to make payments annually but the floating-rate payer to make payments more frequently (semi-annually or quarterly). Also, the way in which interest accrues on each leg of the transaction differs, because there are several day count conventions in the fixed-income markets as discussed in Chapter 3. 

The terminology used to describe the position of a party in the swap markets combines cash market jargon and futures market jargon, given that a swap position can be interpreted as a position in a package of cash market instruments or a package of futures/forward positions. As we have said, the counterparty to an interest rate swap is either a fixed-rate payer or floating-rate payer. Exhibit 19.2 describes these positions in several ways. 

Fixed-Rate Payer Floating-Rate Payer... 

The offer price that the dealer would quote the fixed-rate payer would be to pay 8.85% and receive EURIBOR flat. (The word flat means with no spread.) The bid price that the dealer would quote the floating-rate payer would be to pay EURIBOR flat and receive 8.75%. The bid-offer spread is 10 basis points. 

The fixed rate is some spread above the benchmark yield curve with the same term to maturity as the swap. In our illustration, suppose that the 10-year benchmark yield is 8.35%. Then the offer price that the dealer would quote to the fixed-rate payer is the 10-year benchmark rate plus 50 basis points versus receiving EURIBOR flat. For the floating-rate payer, the bid price quoted would be EURIBOR flat versus the 10-year benchmark rate plus 40 basis points. The dealer would quote such a swap as 40-50, meaning that the dealer is willing to enter into a swap to receive EURIBOR and pay a fixed rate equal to the 10-year benchmark rate plus 40 basis points and it would be willing to enter into a swap to pay EURIBOR and receive a fixed rate equal to the 10-year benchmark rate plus 50 basis points. 

Interest rate swaps trade in a secondary market, where their values move in line with market interest rates, just as bonds values do. If, for instance, a 5-year interest rate swap is transacted at a fixed rate of 5 percent and 5-year rates subsequently fall to 4.75 percent, the swap s value will decrease for the fixed-rate payer and increase for the floating-rate payer. The opposite would be true if 5-year rates moved to 5.25 percent. To understand why this is, think of fixed-rate payers as borrowers. If interest rates fall after they settle their loan terms, are they better off No, because they are now paying above the market rate on their loan. For this reason, swap contracts decrease in value to the ftxed-rate payers when rates fall. On the other hand, floating-rate payers gain from a fall in rates, because... 

There is no net outflow or inflow at the start of these trades, because the 100 million spent on the purchase of the FRN is netted with the receipt of 100 million from the sale of the Treasury. The subsequent net cash flows over the three-year period are shown in the last column. As at the start of the trade, there is no cash inflow or outflow on maturity. The net position is exactly the same as that of a fixed-rate payer in an interest rate swap. For a floating-rate payer, the cash flow would mirror exactly that of a long position in a fixed-rate bond and a short position in an FRN. Therefore, the fixed-rate payer in a swap is said to be short in the bond market—that is, a borrower of funds—and the floating-rate payer is said to be long the bond market. 

In this example, the bank is quoting an offer rate of 5-25 percent, which is what the fixed-rate payer will pay, and a bid rate of 5-19 percent, which is what the floating-rate payer will receive. The bid-offer spread is therefore 6 basis points. The fixed rate is always set at a spread over the government bond yield curve and is often quoted that way. Say the 5-year Treasury is trading at a yield of 4.88 percent. The 5-year swap bid and offer rates in the example are 31 basis points and 37 basis points, respectively, above this yield, and the bank s swap trader could quote the swap rates as a swap spread 37-31. This means that the bank would be willing to enter into a swap in which it paid 31 basis points above the benchmark yield and received LIBOR or one in which it received 37 basis points above the yield curve and paid LIBOR. 

A bank or corporation may buy or sell an option on a swap, known as a swaption. The buyer of a swaption has the right, but not the obligation, to transact an interest rate swap during the life of the option. An option on a swap where the buyer is the fixed-rate payer is termed a call swaption one where the buyer becomes the floating-rate payer is aswaption. The writer of the swaption becomes the buyers counterparty in underlying the transaction. 

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