In an interest-rate swap, two parties (called counterparties) agree to exchange periodic interest payments. The dollar amount of the interest payments exchanged is based on a predetermined dollar principal, which is called the notional principal amount. The dollar amount that each counterparty pays to the other is the agreed-upon periodic interest rate times the notional principal amount. The only dollars that are exchanged between the parties are the interest payments, not the notional principal amount. In the most common type of swap, one party agrees to pay the other party fixed-interest payments at designated dates for the life of the contract. This party is referred to as the fixed-rate payer. The other party, who agrees to make interest rate payments that float with some reference rate, is referred to as the floating-rate payer. The frequency with which the interest rate that the floating-rate payer must pay is called the reset frequency.

The reference rates that have been used for the floating rate in an interest-rate swap are those on various money market instruments: Treasury bills, the London Interbank Offered Rate, commercial paper, banker’s acceptances, certificates of deposit, the federal funds rate, and the prime rate. The most common is the London Interbank Offered Rate (LIBOR). LIBOR is the rate at which prime banks offer to pay on Eurodollar deposits available to other prime banks for a given maturity. Basically, it is viewed as the global cost of bank borrowing. There is not just one rate but a rate for different maturities. For example, there is a one-month LIBOR, three- month LIBOR, and six-month LIBOR.

FundsTo illustrate an interest-rate swap, suppose that for the next five years party X agrees to pay party Y 10% per year, while party Y agrees to pay party X six-month LIBOR (the reference rate). Party X is a fixed-rate payer/floating-rate receiver, while party Y is a floating-rate payer/fixed-rate receiver. Assume that the notional principal amount is $50 million and that payments are exchanged every six months for the next five years. This means that every six months, party X (the fixed-rate payer/floating-rate receiver) will pay party Y $2.5 million (10% times $50 million divided by 2). The amount that party Y (the floating-rate payer/fixed-rate receiver) will pay party X will be six-month LIBOR times $50 million divided by 2. If six-month LIBOR is 7%, party Y will pay party X $1.75 million (7% times $50 million divided by 2). Note that we divide by two because one-half year’s interest is being paid.

Later we will illustrate how market participants can use an interest-rate swap to alter the cash flow character of assets or liabilities from a fixed-rate basis to a floating- rate basis, or vice versa.

Entering into a Swap and Counterparty Risk

Interest-rate swaps are over-the-counter instruments. This means that they are not traded on an exchange. An institutional investor wishing to enter into a swap transaction can do so through either a securities firm or a commercial bank that transacts in swaps. These entities can do one of the following. First, they can arrange or broker a swap between two parties that want to enter into an interest-rate swap. In this case, the securities firm or commercial bank is acting in a brokerage capacity.

The second way in which a securities firm or commercial bank can get an institutional investor into a swap position is by taking the other side of the swap. This means that the securities firm or the commercial bank is a dealer rather than a broker in the transaction. Acting as a dealer, the securities firm or the commercial bank must hedge its swap position in the same way that it hedges its position in other securities that it holds. Also it means that the dealer (which we refer to as a swap dealer) is the counter- party to the transaction. Goldman, Sachs, for example, is a swap dealer. If an institutional investor entered into a swap with Goldman, Sachs, the institutional investor will look to Goldman, Sachs to satisfy the obligations of the swap; similarly, Goldman, Sachs looks to the institutional investor to fulfill its obligations as set forth in the swap. Today, swaps are typically transacted using a swap dealer.

The risks that the two parties take on when they enter into a swap is that the other party will fail to fulfill its obligations as set forth in the swap agreement. That is, each party faces default risk. The default risk in a swap agreement is called counterparty risk. In fact, counterparty risk is more general than the default risk for only a swap agreement. In any agreement between two parties that must perform according to the terms of a contract, (counterparty risk is the risk that the other party will default. With futures and exchange-traded options, the counterparty risk is the risk that the clearinghouse established to guarantee performance of the contracts will default. Market participants view this risk as small. In contrast, counterparty risk in a swap can be significant.

Because of counterparty risk, not all securities firms and commercial banks can be swap dealers. Several securities firms have actually established subsidiaries that are separately capitalized so that they have a high credit rating, which permits them to enter into swap transactions as a dealer. Thus it is imperative to keep in mind that any party who enters into a swap is subject to counterparty risk.

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Interest-Rate Swaps