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Amortizing Swap Definition
An Amortizing Swap is an instance of interest rate swap in which the notional principal amount decreases during the life cycle of the swap. Usually, two parties are involved in an amortization swap deal, there is also an agreed schedule or formula that both parties adhered to in amortizing swap.
In an amortizing swap deal, the decline in the notional principal might be based on the interest rate tied to the prepayment or an interest benchmark. The payment in amortizing swap are based on an agreed principal amount that declines over time, one of the parties pays a fixed interest rate while the other pays a floating interest rate.
A Little More on What is an Amortizing Swap
An amortizing swap can also be called a write-down swap wherein two parties agree to make payments at a fixed rate and floating rate. This form of swap is derivative, decline in the nominal principal amount determine payments by both parties. Usually, individuals use amortization to either increase or reduce interest rate in a way that will benefit them.
In amortizing swap deals, the counterparties involved agreed to amortize future payment flows when there is a decline interest rates or when the notional principal amount reduces. One significant thing about amortizing swaps is that at a scheduled date, the notional principal amount declines and one of the parties pays a fixed rate while the other pays a floating rate.
Amortizing swaps are used mostly in the real estate industry or mortgage industry, they are called over-the-counter (OTC) transactions. They are derivative arrangements in which two counterparties agree to exchange certain cash flows for other cash flows, the exchange is done at a scheduled time and based on an agreed notional principal amount.
Amortizing swaps are established to achieve certain goals and there are precise specifications that must be agreed to by the parties involved. Interest rate swaps can be done based on the rate tied to the prepayment of a mortgage or based on rate benchmark such as the London Interbank Offered Rate (LIBOR).
Amortizing Swap Interest
In amortizing swap interest transactions, the counterparties involved agree to make exchanges or payments based on agreed schedules or reference rates. For example, it is possible for an investment property owner to borrow in the real estate industry through short-term self-interest loans or even LIBOR mortgages. Before the deal is initiated, the two parties involved can sign swap agreements that stipulate that fixed interest rates would be turned to floating rates at a fixed date. This is often done to prevent mortgage rates from increasing and also reducing other risks.
References for Amortizing Swap
Academic Research for Amortizing Swap
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Counterparty risk pricing under correlation between default and interest rates, Brigo, D., & Pallavicini, A. (2007). Numerical Methods for Finance, 63, 7.
Financial derivatives: applications and policy issues, Sangha, B. S. (1995). Business Economics, 46-52.
Risk management for middle market companies, Moore, J., Culver, J., & Masterman, B. (2000). Journal of Applied Corporate Finance, 12(4), 112-119.
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The pricing and hedging of index amortizing rate swaps, Fernald, J. D. (1993). FRBNY Quarterly Review, 71-74.
Evaluating and hedging exotic swap instruments via LGM, Hagan, P. S. (2009). Bloomberg Technical Report.
Deriving closed-form solutions for Gaussian pricing models: A systematic time-domain approach, Levin, A. (1998). International Journal of Theoretical and Applied Finance, 1(03), 349-376.
Financial Engineering and Computation, Lyuu, Y. D. (2002). Mathematics. Algorithms” Canbridge University pass, 155-173.
The Nature of Interest Swaps and the Pricing of Their Risks., Khoury, S. J. (1990). Journal of Accounting, Auditing & Finance, 5(3).