Interest Rate Swap Definition
An interest rate swap is a form of contract where the parties agree to exchange or swap the interest payments on two securities. It is primarily a tool used by bond investors.
A company that has issued corporate bonds seeks to improve its cash flow. It seeks to change the fixed rate on its corporate bonds for a floating rate. In this situation, the company can enter a swap with a counter-party bank wherein the company gets a fixed rate and also pays a floating rate.
This rate exchange transaction is designed to match both the cash flow and maturity of the fixed-rate bond, and thus, the two fixed-rate streams of payment are netted. The company the bank decide on the floating-rate index. Generally, this agreements uses LIBOR for maturity rates of one month, three months, or six months. The company would get the London Inter-bank Offer Rate plus/minus a spread which shows interest rate market conditions. There may also be a discount or premium based upon the company’s credit rating.
Floating to Fixed
A company which has no access to a fixed-rate loan can decide to borrow at a rate that’s floating, thus entering into a swap in a bid to accomplish a fixed rate. The tenor, reset, and payment dates for the floating rates stated on the loan, reflect on the swap and are netted. The swap’s fixed-rate leg then becomes the borrowing rate of the company.
Float to Float
Sometimes, companies enter into a swap in order to change the floating rate index type or tenor that they pay. This is referred to as a basis swap. A company is capable of swapping from LIBOR of three months to that of six months. For instance, either because it has a more attractive rate or because it corresponds with other flows of payment. A company is also capable of switching to an entirely different index like the commercial paper, federal funds rate, or the Treasury bill rate.
References for Interest Rate Swap
- https://www.investopedia.com › Trading › Trading Strategy
- https://www.thebalance.com › Investing › US Economy › U.S. Markets
- https://corporatefinanceinstitute.com › Resources › Knowledge › Finance
Research articles for Interest Rate Swap
An econometric model of the term structure of interest‐rate swap yields, Duffie, D., & Singleton, K. J. (1997). The Journal of Finance, 52(4), 1287-1321.
An analytic solution for interest rate swap spreads, Grinblatt, M. (2001). International Review of Finance, 2(3), 113-149.
Fiscal policy events and interest rate swap spreads: Evidence from the EU, Afonso, A., & Strauch, R. (2007). Journal of International Financial Markets, Institutions and Money, 17(3), 261-276.
An economic analysis of interest rate swaps, Bicksler, J., & Chen, A. H. (1986). The Journal of Finance, 41(3), 645-655.
Determinants of interest rate swap spreads, Lang, L. H., Litzenberger, R. H., & Liu, A. L. (1998). Journal of Banking & Finance, 22(12), 1507-1532.
The market price of credit risk: An empirical analysis of interest rate swap spreads, Liu, J., Longstaff, F. A., & Mandell, R. E. (2002). (No. w8990). National Bureau of Economic Research.
Interest rate swaps and corporate financing choices, Titman, S. (1992).The Journal of Finance, 47(4), 1503-1516.
Expected budget deficits and interest rate swap spreads-Evidence for France, Germany and Italy, Heppke-Falk, K., & Hüfner, F. P. (2004).
Identifying the factors that affect interest‐rate swap spreads: some evidence from the United States and the United Kingdom, Lekkos, I., & Milas, C. (2001). Journal of Futures Markets: Futures, Options, and Other Derivative Products, 21(8), 737-768.