Interest rate swaps

A bond s swap spread is a measure of the credit risk of a bond relative to the interest-rate swap market. Because the swap is traded by banks, or interbank market, the credit risk of the bond over the interest-rate swap is given by its spread over the IRS. In essence, then the IRS represents the credit risk of the interbank market. If an issuer has a credit rating superior to that of the interbank market, the spread will be below the IRS level rather than above it. 

Z-spread is an alternative spread measure to the ASW spread. This type of spread uses the zero-coupon yield curve to calculate the spread, in which in this case is assimilated to the interest-rate swap curve. Z-spread represents the spread needful in order to obtain the equivalence between the present value of the bond s cash flows and its current market price. However, conversely to the ASW spread, the Z-spread is a constant measme. 

There is a 100 — P up-front payment to purchase the asset in return for par. For the interest-rate swap, we have... 

The concept of the single-currency curve is straightforward and is covered in detail elsewhere in this chapter. Here we consider the concept of the multicurrency curve. As this is most relevant to collateralised interest-rate swaps (IRS), we place the discussion in this context. 

Asset-swap spread It is determined by combining an interest-rate swap and cash bond. Generally, bonds pay fixed coupons therefore, it will be combined with an interest-rate swap in which the bondholder pays fixed coupons and receives floating coupons. The spread of the floating coupon over an interbank rate is the asset-swap spread. ... 

Another approach is to compare the floating-rate note with a derived yield of a fixed-rate bond by using an interest rate swap curve matched with floater coupons. Figure 10.4 shows the Bloomberg YASN screen for Mediobanca float... 

The fundamental principle of valuation is that the value of any financial asset is equal to the present value of its expected future cash flows. This principle holds for any financial asset from zero-coupon bonds to interest rate swaps. Thus, the valuation of a financial asset involves the following three steps ... 

Government bond markets are closely related to other fixed income assets and interest rate and bond futures. This market is also increasingly related to the interest rate swap market. 

Interest Rate Swaps as the Benchmark Curve ter Eure Bevies... 

Exhibits 7.5 and 7.6 show relevant spreads for market participants who use Bunds or interest-rate swaps to hedge their holdings. 

Market makers in sterling interest rate swaps. 

One solution to this problem, of course, is for the company to enter into a 5-year interest rate swap on a notional principal of 1 million, agreeing to pay the fixed rate and receive the floating rate. In our illustration, the fixed rate might be 3%, in which case the company would effectively lock into paying the fixed rate of 3% per annum over the 5-year period. While this protects the company against higher interest rates, the company cannot benefit from lower rates, especially at the outset when rates are just 2%. 

In this way, an interest rate cap allows the borrowing company to benefit when interest rates are low, while protecting the company when interest rates are high. This is marvellous, as it provides the best of both worlds, but such a result does not come free As with other interest rate options, the company would have to pay an up-front premium to purchase the cap. In the example here, this up-front premium might be around 165 bp of the notional principal, i.e., 16,500, which is equivalent to around 35 bp per annum if this cost were spread over the lifetime of the cap. This caps the effective EURIBOR at around 3.35% rather than 3%. Contrast this with the interest rate swap, which does not involve an up-front payment, but penalizes the company with a higher initial interest rate instead. 

Swaptions are options that allow the buyer to obtain at a future time one position in a swap contract. It is quite elementary that an interest rate swap, fixed for floating, can be understood as a portfolio of bonds.To consider this assume that the notional principal is 1. Then the claim on the fixed payments is the same as a bond paying coupons with the rate p and no principal. Let X be the time when the swap is conceived. The claim on the fixed income stream is worth, at time X,... 

The reference rates that have been used for the floating rate in an interest rate swap are various money market rates. The most common in Europe is EURIBOR. EURIBOR is the rate at which prime banks offer to pay on euro deposits available to other prime banks for a given maturity. There is not just one rate but a rate for different maturities. For example, there is a 1-month EURIBOR, 3-month EURIBOR, and 6-month EURIBOR. 

Interest rate swaps are over-the-counter instruments. This means that they are not traded on an exchange. An institutional investor wishing to enter into a swap transaction can do so through either a securities firm or a commercial bank that transacts in swaps. These entities can do one of the following. First, they can arrange or broker a swap between two parties that want to enter into an interest rate swap. In this case, the securities firm or commercial bank is acting in a brokerage capacity. 

Consider the hypothetical interest rate swap nsed earlier to illustrate a swap. Let s look at party X s position. Party X has agreed to pay 10% and receive 6-month EURIBOR. More specifically, assuming a 50 million notional amount, X has agreed to buy a commodity called 6-month EURIBOR for 2.5 million. This is effectively a 6-month forward contract where X agrees to pay 2.5 million in exchange for deliv-... 

Consequently, interest rate swaps can be viewed as a package of more basic interest rate derivative instruments—forwards. The pricing of an interest rate swap will then depend on the price of a package of forward contracts with the same settlement dates in which the underlying for the forward contract is the same reference rate. 

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. 

Source Robert F. Kopprasch, John Macfarlane, Daniel R. Ross, and Janet Showers, The Interest Rate Swap Market Yield Mathematics, Terminology, and Conventions, Chapter 58 in Frank J. Fabozzi and Irving M. Pollack (eds.). The Handbook of Fixed Income Securities (Fiomewood, IL Dow Jones-Irwin, 1987). 

In an interest rate swap, the counterparties agree to exchange periodic interest payments. The euro amount of the interest payments exchanged is based on the notional principal. In the most common type of swap, there is a fixed-rate payer and a fixed-rate receiver. The convention for quoting swap rates is that a swap dealer sets the floating rate equal to the reference rate and then quotes the fixed rate that will apply. 

It was useful to show the basic features of an interest rate swap using quick calculations for the payments such as described above and then explaining how the parties to a swap either benefit or hurt when... 

At the initiation of an interest rate swap, the counterparties are agreeing to exchange future payments and no upfront payments by either party are made. This means that the swap terms must be such that the present value of the payments to be made by the counterparties must be at least equal to the present value of the payments that will be received. In fact, to eliminate arbitrage opportunities, the present value of the payments made by a party will be equal to the present value of the payments received by that same party. The equivalence (or no arbitrage) of the present value of the payments is the key principle in calculating the swap rate. 

Once the swap transaction is completed, changes in market interest rates will change the payments of the floating-rate side of the swap. The value of an interest rate swap is the difference between the present value of the payments of the two sides of the swap. The 3-month EURIBOR forward rates from the current EURIBOR futures contracts are used to (1) calculate the floating-rate payments and (2) determine the discount factors at which to calculate the present value of the payments. 

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