Interest Rate Swaps--A Primer
TASA ID: 1464
Interest rate swaps are the most commonly traded derivatives. The market for swaps is huge, estimated in the hundreds of trillions of dollars worldwide.
An interest rate swap is a contractual agreement whereby one party exchanges a stream of interest payments for another party's stream of cash flows.
The most common interest rate swap is one where fixed-rate payments are exchanged for floating-rate payments based on a notional amount of principal. The floating rate is pegged to a reference rate, usually the LIBOR. The amount of principal is notional because no principal needs to be exchanged if the transaction is in the same currency.
As an example, let us assume that Party A agrees to pay Party B periodic payments at the fixed rate ("the swap rate") of 4.0% in exchange for periodic payments at the variable rate of LIBOR plus 100 bps (1.0%) on the notional amount of $10 million of principal. If LIBOR at some payment date is 2.0%, the net payment from A to B will be 4.0-2.0-1.0=1.0%.
Interest rate swaps are used for various purposes, such as hedging a contractual exposure or speculating on changes in interest rates. A bank may have granted a customer a fixed-rate loan, but would prefer to have revenues from that loan more in line with its borrowing cost. The bank then enters into a fixed-for-floating swap with an institution (e.g. a hedge fund) which speculates on profiting from a decrease in interest rates.
The Chicago Board of Trade (CBOT), a subsidiary of the CME Group, maintains an active market in 5-, 7-, 10- and 30-year interest rate swap futures. The website at www.cmegroup.com shows specifications for all contracts.
Recently the International Derivatives Clearing Group, LLC (IDGC), a majority-owned, independently operated subsidiary of The NASDAQ OMX Group, started clearing interest rate swaps through the mechanism of "exchange futures for swaps" (EFS) to accept consummated transactions from a number of independent execution venues. NASDAQ OMX-owned Philadelphia Board of Trade (PBOT) is the designated contract maker for the products.
While transactions on the CBOT and PBOT are regulated by the Exchanges and the Commodity Futures Trading Commission (CFTC), over-the-counter transactions are largely unregulated. The Obama Administration will likely increase regulatory scrutiny over these (and other) derivative transactions due to the current financial crisis.
In any contractual agreement, especially if more than two parties are involved, default or perhaps even fraud by any of the parties is always a possibility. The present economic situation makes such events more likely to happen, which could then lead to litigation.
This article discusses issues of general interest and does not give any specific legal, medical, or business advice pertaining to any specific circumstances. Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.
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