SmartInMoney

 

 

The most popular interest rate swaps are fixed-for-floating swaps, also called as vanilla interest rate swaps, which is an exchange of interest payments on a specific principal amount. It involves exchanging a fixed amount per payment period for a payment that is not fixed. The floating side of the swap would usually be linked to another interest rate, often a 3-month or 6-month LIBOR as its floating rate. In an interest rate swap, the principal amount is never exchanged; it is just a notional principal amount.

 

The periodic interest payments are generally scheduled to occur on concurrent dates, so they too can be netted. On a payment date, it is normally the case that only the difference between the two payment amounts is turned over to the party that is entitled to it, as opposed to exchanging the full interest amounts.

 

Interest rate swaps are used for many purposes. If a corporation has borrowed money at a floating rate of interest but would prefer to lock in a fixed rate, it can swap its floating rate payments into fixed rate payments.

 

Vanilla interest rate swaps are quoted in terms of the fixed rate to be paid against the floating index. The fixed rate is usually quoted as an absolute rate, for example a quote of 4.3% against 3-month LIBOR would indicate that the fixed rate would be 4.3% paid quarterly. The fixed rates on vanilla swaps are called swap rates. The floating rate is always "flat" that is any spreads are added or subtracted from the fixed rate only. In USD markets, vanilla swaps are often quoted, not as an absolute rate, but as the fixed rate's spread over the corresponding Treasury yield.

 

There is also a liquid market for floating-floating interest rate swaps, which are known as basis swaps. A simple example is a swap of 1-month USD LIBOR for 6-month USD LIBOR. More common are basis swaps between two floating indexes from different segments of the money market. A bank that lends at prime but finances itself at LIBOR would be a natural user of a prime-Libor basis swap. The bank would be using the swap to eliminate basis risk. It is this general application from which basis swaps derive their name.