Interest rate swaps applications

One straightforward application of an interest rate swap is to convert a floating-rate liability into a fixed-rate one, usually in an effort to remove exposure to anticipated upward moves in interest rates. Say a company has borrowed money at a floating rate of 100 basis points over sbc-month LIBOR. Fearing that interest rates will rise in the three years remaining on the loan, it enters into a three-year semiannual interest rate swap with a bank, depicted in FIGURE 7.8, in which it pays a fixed rate of 6.75 percent and receives six-month LIBOR. This fixes the company s borrowing costs for three years at 6.75 percent plus 100 basis points, or 7-75 percent, for an effective annual rate of 7-99 percent. 

To derive the swap term structure, observed market interest rates combined with interpolation techniques are used also, dates are constructed using the applicable business-day convention. Swaps are frequently con-strncted nsing the modified following bnsiness-day convention, where the cash flow occurs on the next business day unless that day falls in a different month. In that case, the cash flow occurs on the immediately preceding business day to keep payment dates in the same month. The swap curve yield calculation convention frequently differs by currency. Exhibit 20.2 lists the different payment frequencies, compounding frequencies, and day count conventions, as applicable to each currency-specific interest rate type. 

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