Trade Type –
Interest Rate Swap
Description
An interest rate swap is a kind of trade where two parties agree to the exchange of interest payments one or more times.
In a fixedforfloat swap, one party will pay (or receive) an amount that is fixed, meaning predetermined at the time of the trade and the other party will receive (or pay) an amount that is ‘floating’, meaning the precise amount isn’t known, at the time of the trade. Since the exact amount of the floating payment is not known at the time of the trade, both parties must agree on a method for determining the exact amount of the interest payment.
The method of determining the exact amount of the interest payment amount for the floating side of the trade will usually involve the following items:
a) Agreeing to an objective third party to act as a reference source of interest rates. A third party, meaning not one of the two original counterparties of the swap, is needed to be fair as the third party could be more objective since the third party would not have a stake in the specific outcome of the swap, i.e., would not want to influence the swap payments to be too high or too low. The objective third party is typically an organization that will publish interest rates each day. A commonly used organization is the organization of banks that collectively publish LIBOR, the London Interbank Offered Rate.
b) Agreeing to a date or series of days on which the two parties would look up the reference interest rate.
c) Agreeing to the tenor of the interest rate. E.g., a popular tenor is ‘3 months’. As a bit more on what ‘tenor’ means… consider that banks will quote different interest rates based on how long you would borrow money or agree to give money to the bank. E.g., A ‘CD’, meaning ‘Certificate of Deposit’, might have had these interest rates as of a particular date in 2007.
3 months: 4%
6 months: 4.3%
1 year: 5%
The point here is that it is not enough to specify which day to look for the interest rate for the floating side of your interest rate swap, e.g., assume that date is 15Oct2011… you also need to specify the tenor of the interest rate on that day, e.g., 3 month, 6 month, or 1 year.
d) The yield basis. This is used to compute the exact number of days in the time period. For example, for a 3 month tenor… we could count the exact number of days in the 3 months… or we could just assume that all 3 month periods have the same number of days, e.g., typically 90 days is assumed for people who use this method.
As a bit more on the concept of a swap of interest payments… In order to calculate an interest payment you also need a notional amount, i.e., the amount that the interest payment is based on. The notional amount is typically the same for both the fixed and floating side of the swap. As a simplified example of a ‘notional amount’, each party might agree on a notional amount of $1,000,000 (a million dollars). For example, if one side was paying a fixed interest rate of 5% per year simple interest… then the interest payment would be $1,000,000 * 5% = $50,000. The $50,000 is the interest payment (which may be payable once a year) and the $1,000,000 is the notional amount. In an interest rate swap… only the interest payments are swapped, e.g., the party paying the fixed amount pays the $50,000, not the $1,000,000 which is the notional amount of the trade. I.e., no party pays out the $1,000,000.
Furthermore… payments are typically netted. So if one party is responsible to pay the $50,000 fixed amount of the interest payment and the other party is responsible to pay $49,000 (suppose that the $49,000 is the final amount due from the floating side payment after the final payment was determined)… the typically the party who is responsible to pay the most just pays the net amount, meaning the difference in the two payments, in this case $1,000. In other words, instead of one party paying $50,000 and getting back, i.e., receiving, $49,000 from the other party… the first party just pays out $1,000 and the other party pays out nothing (just gets the $1,000).
Example
Two parties… we’ll call the ‘Party A’ and ‘Party B’ agree to a fixed for float interest rate swap with a notional of $1,000,000 for a period of two years, covering the calendar years 2012 and 2013, i.e., from January 1, 2012 to December 31, 2013. Party A will pay interest payments based on a fixed rate of 5% every 6 months. Party B will pay (so ‘Party A’ receives) interest rates based on the LIBOR 3 month rate plus 1% every three months. Note that the payment periods are not equal, i.e., Party A will make 4 payments in total over the two year period (one every six months) and Party B will make 8 payments in total over the two years (one every 3 months).
Summary:
Time Frame: Jan 1, 2012 to Dec 31, 2013
Notional: $1,000,000
Fixed Rate: 5%
Floating Rate: Whatever 3 month LIBOR is as of certain dates in the timeframe of the swap plus an additional 1%.
Here are some example payment amounts, payment dates, and estimated interest rates and interest rate determination dates (for the floating side of the swap).
Fixed Side of Swap – Party A pays these interest payments
Rate Determination Date 
Notional 
Interest Rate 
Interest Payment 
Payment Date 
Not Applicable 
$1,000,000 
5% 
$25,000 
30Jun2012 
Not Applicable 
$1,000,000 
5% 
$25,000 
31Dec2012 
Not Applicable 
$1,000,000 
5% 
$25,000 
30Jun2013 
Not Applicable 
$1,000,000 
5% 
$25,000 
31Dec2013 
Some notes on the fixed payments
1) The interest payments are based on a 5% rate per year. However, since they are paid every 6 months, we are counting the rate as 2.5% for each six month period. So you interest payment is 5% * time * notional = 5%/year * 1/2 year * $1,000,000 = $25,000
2) The payment dates are simplified for this example. For a real swap, the payment days would typically be based on days that are typical for market conventions for the two parties doing the swap. Payment dates would be usually be adjusted to land on good business day, i.e., not weekends or holidays. E.g., Jun 30, 2012 is actually a Saturday.
Fixed Side of Swap – Party B pays these interest payments
Rate Determination Date 
Notional 
Estimated Interest Rate 
Spread 
Estimated Total Interest Rate (includes Spread) 
Estimated Interest Payment 
Payment Date 
01Jan2012 
$1,000,000 
4.5% 
1% 
5.5% 
$13,750 
31Mar2012 
01Apr2012 
$1,000,000 
4.6% 
1% 
5.6% 
$14,000 
30Jun2012 
01Jul2012 
$1,000,000 
4.7% 
1% 
5.7% 
$14,250 
30Sep2012 
01Dec2012 
$1,000,000 
4.8% 
1% 
5.8% 
$14,500 
31Dec2012 
01Jan2013 
$1,000,000 
4.9% 
1% 
5.9% 
$14,750 
31Mar2013 
01Apr2013 
$1,000,000 
5.0% 
1% 
6.0% 
$15,000 
30Jun2013 
01Jul2013 
$1,000,000 
5.1% 
1% 
6.1% 
$15,250 
30Sep2013 
01Dec2013 
$1,000,000 
5.2% 
1% 
6.2% 
$15,500 
31Dec2013 
Some notes on the floating payments
1) The ‘estimated interest rate’ is a projected rate as of the trade date and made up for this example. The rates will be finalized on the ‘rate determination date’ and so will go from ‘unknown’ to ‘known’ or ‘estimated/projected’ to ‘known’.
2) Both the ‘Rate Determination Dates’ and the ‘Payment Dates’ are simplified for this example, e.g., for a real trade, no rate determination dates and no payment days would be on a weekend or holiday. It is usual that the payment payment date to be at least a few days after the rate determination date’ to give the operations groups at firms time to process the payments. I.e., Firms can generate invoices only after the final payment amount is known, i.e., after the rate determination date.
3) The interest payment in this example is calculated based on exactly 1/4 year, which may be simplified relative to a real trade, which might use the actual number of days for each 3 month period. E.g., for the first interest payment it is
notional * interest rate * time = $1,000,000 * 1/4 year * 5.5%/year = $13,500
Some more notes on this example…
1) The sum of the payments that Party A makes is $25,000 * 4 = $100,000. Based on the estimated interest rates above, Party B is expected to pay, so Party A is expected to receive $117,000. So for this example, things seem to be more favorable to ‘Party A’.
Reason to Buy
Reason to buy goes here
Reason to Sell
Reason to sell goes here
MTM Valuation
MTM Valuation goes here
PnL Explained Attributes
# 
Attribute 
Applicable 

1 
Impact of New Trades 
Yes 

2 
Impact of Amendments 
Yes 

3 
Impact of Cancelations 
Yes 

4 
Impact of Time 
Yes 

5 
Impact of Commodity Prices For the sensitivities approach:

No 

6 
Impact of Interest Rates For the sensitivities approach:

Yes 

7 
Impact of Volatility For the sensitivities approach:

No 

8 
Impact of Cross Price/Volatility 
No 

9 
Impact of Correlations 
No 
Additional PnL Explained
Attributes
Not applicable for this trade type
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