So far we have merely described an interest-rate swap and looked at its characteristics. Here we illustrate how they can be used in asset/liability management. Other types of interest-rate swaps have been developed that go beyond the generic or “plain vanilla” swap described and we describe these later.
An interest-rate swap can be used to alter the cash flow characteristics of an institution’s assets so as to provide a better match between assets and liabilities. The two institutions we use for illustration are a commercial bank and a life insurance company. Read the rest of this entry »
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. Read the rest of this entry »
