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Unit 9: Interest Rate and Currency Swaps

Reset Date: The applicable LIBOR for each period is to be determined before the date of Notes
payment. It is usually determined before the commencement of the applicable period.
Generally for the first payment, the LIBOR rate applicable will be set at the trade date if the
value date is two days after the trade date. The first reset date will generally be two days
before the 1st payment date, the second reset date will be two days before the 2nd payment
date and so on.

Maturity Date: The date on which the interest accrual stops.
Assignment Broker: Market maker in swaps.
LIBOR: London Inter Bank Offered Rate, which is a rate decided on daily basis based on a
sample of lending rates offered by leading banks in London. The 6-month LIBOR is mostly
used for swaps implying that this is the rate payable for borrowing US dollars for six
months in London.

Self Assessment

State whether the following statements are true or false:
5. Swaps are mutual obligations among the swap parties.

6. A swap broker is also called a market maker.

9.4 Interest Rate Swaps

An interest rate swap is a contractual agreement entered into between two counterparties under
which each agrees to make periodic payment to the other for an agreed period of time based
upon a national amount of principal (IRS). The two parties that agree to exchange the cash flows
are called counterparties of the swap. The principal amount is notional because there is no need
to exchange actual amounts of principal in a single currency transaction: there is no foreign
exchange component to be taken account of. Equally, however, a notional amount of principal
is required in order to compute the actual cash amounts that will be periodically exchanged.
It is important to note two points:
There is no exchange of principal amount either initially or on maturity, as the notional
principal amount is the same.
On each interest payment date, only the net amount will be paid/received by the
counterparties.
Thus, an interest rate swap is a financial contract between two parties exchanging or swapping
a stream, of interest payments on a notional principal amount on multiple occasions during a
specified period. Such contracts generally involve the exchange of a fixed-to-floating or floating-
to-floating rates of interest. Accordingly, on each payment date, that occurs during the swap
period, a cash payment based on the differential between fixed and floating rates, is made out by
one party involved in the contract to another.

9.4.1 Characteristics of Interest Rate Swaps

Interest rate swaps have the following characteristics:
1. Effectively converts a floating rate borrowing to fixed rate or vice-versa.

2. Structured as a contract separate from the underlying funding.
3. Principal repayment obligations are not exchanged i.e. the principal amount is only
notional.

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