Interest rate swaps can get quite complicated, but in their simplest form, they collapse just a few steps away. These companies can exchange their interest rates without affecting their loans, and without including their borrowing rates. They do this by entering into a contract to exchange interest rates. The contract gives the amount of fictitious capital, the rates that the companies will pay, the due dates of the payments and the date the swap matures. For this example of an interest rate swap, ABC has a 1-month LIBOR-linked variable rate loan, but wants its rate to be indexed to the 6-month LIBOR. Instead of swapping a fixed price for a variable price, he exchanges one kind of variable interest rate for another. The duration of the loan is a linear reconciliation of the evolution of the loan price for a certain change in yield. Investors use duration and convexity to predict how the price of a loan will react to changes in interest rates. A derivative is a financial contract that derives its value from the exchange of an underlying. In the case of an interest rate swap, the interest rate (or cash flow based on the interest rate) is the asset.

A German company might want to exchange its debt in euros for debts in U.S. dollars. The U.S. company intends to exchange its debt in USD for debt on the basis of the EURO. The German company would borrow dollars from the U.S. company while the U.S. company borrows euros from German. They would repay the loans at the end of the contract. 2. Enter a clearing swap: For example, Company A could enter a second swap from the above interest rate swap, receive a fixed interest rate this time and pay a variable interest rate. A swap may also include replacing one type of variable interest rate with another, called a base swap.

Interest rate swaps typically include the exchange of a flow of future payments on the basis of a fixed interest rate for another rate of future payments based on a variable rate. Therefore, understanding the concepts of fixed-rate loans versus variable rate loans is essential to understanding interest rate swaps. For example, Company C, a U.S. company, and Company D, a European company, enter into a five-year currency exchange for $50 million. Suppose the exchange rate is at that time at $1.25 per euro (z.B. the dollar is worth 0.80 euro). First, companies will exchange contractors. So company C pays $50 million and company D 40 million euros.

This meets the needs of each company in funds denominated in a different currency (which is the reason for the swap). Note: Interest rate swaps and futures are the two examples of derivatives. While bond futures are derived from bonds, interest rate swaps receive their value from the cash flows exchanged. Interest rate swaps are traded over the counter and if your company decides to exchange interest rates, you and the other party must agree on two main topics: the NPV calculates the current value of all total payments. This is done by estimating the payment for each year in the future for the duration of the loan. Future payments will be updated to reflect inflation. The discount rate also fits what the money would have repaid if it had been in a risk-free investment such as Treasury bonds. The two companies enter into a two-year interest rate swap agreement with a reported face value of $100,000.

Company A offers Company B a fixed interest rate of 5% in exchange for obtaining a variable rate of the LIBOR rate plus 1%. The current LIBOR rate at the beginning of the interest rate swap contract is 4%. As a result, the two companies are first on an equal footing, both receiving 5%: Company A has a fixed interest rate of 5% and Company B receives the LIBOR rate of 4% plus 1% – 5%. For example, on December 31, 2006, Company A and Company B will enter into a five-year swap with the following conditions: A vanilla IRS is the term used for standardized IRS. As a general rule