Here we review some of the terminology used in the swaps market and explain how swaps are quoted. The date that the counterparties commit to the swap is called the trade date. The date that the swap begins accruing interest is called the effective date, and the date that the swap stops accruing interest is called the maturity date.

Although our illustrations assume that the timing of the cash flows for both the fixed-rate payer and floating-rate payer will be the same, this is rarely the case in a swap. In fact, an agreement may call for the fixed-rate payer to make payments annually but the floating-rate payer to make payments more frequently (semiannually or quarterly). Also, the way in which interest accrues on each leg of the transaction differs, because there are several day-count conventions in the fixed-income markets.

The terminology used to describe the position of a party in the swap markets combines cash market jargon and futures jargon, given that a swap position can be interpreted as a position in a package of cash market instruments or a package of futures/forward positions. As we have said, the counterparty to an interest-rate swap is either a fixed-rate payer or floating-rate payer. Exhibit 25-2 describes these positions in several ways.

FundsThe first two expressions in Exhibit 25-2 to describe the position of a fixed-rate payer and floating-rate payer are self-explanatory. To understand why the fixed-rate payer is viewed as short the bond market and the floating-rate payer is viewed as long the bond market, consider what happens when interest rates change. Those who borrow on a fixed-rate basis will benefit if interest rates rise because they have locked in a lower interest rate, but those who have a short bond position will also benefit if interest rates rise. Thus a fixed-rate payer can be said to be short the bond market. A floating-rate payer benefits if interest rates fall. A long position in a bond also benefits if interest rates fall, so terminology describing a floating-rate payer as long the bond market is not surprising. From our discussion of the interpretation of a swap as a package of cash market instruments, describing a swap in terms of the sensitivities of long and short cash positions follows naturally.

EXHIBIT 25-2 DESCRIBING THE COUNTERPARTIES TO A SWAP

Fixed-Rate Payer

  1. Pays fixed rate in the swap
  2. Receives floating in the swap
  3. Is short the bond market
  4. Has bought a swap
  5. Is long a swap
  6. Has established the price sensitivities of a longer-term liability and a floating-rate asset

Floating-Rate Payer

  1. Pays floating rate in the swap Receives fixed in the swap
  2. Is long the bond market
  3. Has sold a swap
  4. Is short a swap
  5. Has established the price sensitivities of a longer-term asset and a floating-rate liability

The convention that has evolved for quoting swaps levels is that a swap dealer sets the floating rate equal to the index and then quotes the fixed rate that will apply. To illustrate this convention, consider a 10-year swap offered by a dealer to market pa ti pants shown in Exhibit 25-3.

The offer price that the dealer would quote the fixed-rate payer would be to pa 8.85% and receive LIBOR “flat” (”flat” meaning with no spread to LIBOR). The bid price that the dealer would quote the floating-rate payer would be to pay LIBOR flat and receive 8.75°/0. The bid-offer spread is 10 basis points.

The fixed rate is some spread above the Treasury yield curve with the same term to maturity as the swap. In our illustration, suppose that the 10-year Treasury yield is 8.35%. Then the offer price that the dealer would quote to the fixed-rate payer is the 10-year Treasury rate plus 50 basis points versus receiving LIBOR flat. For the floating-rate payer, the bid price quoted would be LIBOR flat versus the 10-year Treasury rate plus 40 basis points. The dealer would quote such a swap as 40-50, meaning that the dealer is willing to enter into a swap to receive LIBOR and pay a fixed rate equal to the 10-year Treasury rate plus 40 basis points, and it would be willing to enter into a swap to pay LIBOR and receive a fixed rate equal to the 10-year Treasury rate plus 50 basis points. The difference between the Treasury rate paid and received is the bid-offer spread.

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TERMINOLOGY, CONVENTIONS, AND MARKET QUOTES