Interest Rate Swap. A vehicle to hedge against interest rate risk

Seminar Paper, 2016

17 Pages, Grade: 1,3


Table of Contents

List of Figures

List of Tables


1 Introduction

2 Basics of interest rate swaps
2.1 Reference rate and credit rating
2.2 Net present value (NPV) of interest rate swaps
2.3 Equilibrium of interest rate swaps
2.4 Sample calculation of an interest rate swap according to Perdion / Steiner

3 Genesis, classification of interest rate swaps and the need for risk mitigation of interest rates
3.1 Genesis of swaps
3.2 Classification of OTC swaps
3.3 Special interest rate risks in the lending business

4 Types of interest rate swaps
4.1 Coupon swap
4.2 Basis swap
4.3 Step up interest rate swaps
4.4 Amortisation interest rate swaps
4.5 Interest rate swaption
4.6 Forward interest rate swap

5 Conclusion

List of Literature and Sources


List of Figures

Figure 1: Interest rate counterparties

Figure 2: Current EURIBOR rates

Figure 3: Present value parties

Figure 4: Interest rate swaps market development since 1998

Figure 5: Payer & receiver swap

Figure 6: Floating to floating interest rate swap

Figure 7: Interbank rate three-month money in the US 1960-2015

Figure 8: Annual exchange rate of the U.S. dollar to Euro from 2003 to 2015

Figure 9: Inflation in Germany 1950-2015

Figure 10: OTC, interest rate derivates

Figure 11: Credit worthiness classification of Deutsche Bundesbank

List of Tables

Table 1: Starting Position

Table 2: Interest rate swap advantage


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1 Introduction

Every action involves risks. This applies to companies operating in the market and also in particular to credit institutions whose raison d'être lies in the assumption of risks.[1]

Risk in the literal sense is grounded in a lack of awareness of the possibility of negative deviation from planned corporate goals.[2]

To generate income and to be able to survive a company has to take risk. Such risks are different in nature and are therefore to be evaluated differently[3]. Banks generate the majority of their income from interest-bearing business. Companies finance their borrowing requirements next to equity mainly through loans.

With regards to borrowing costs it is to be noted that corporate risk also shows a dependency between total capital and interest on debt. This is known as the leverage effect which in a negative scenario may be so large that the resulting losses can no longer be compensated.[4]

The change in economic conditions, fluctuations of interest rates (IR) and exchange rates on the capital markets especially due to inflation at the beginning of the 70s and 80s were the trigger for the development of new financial instruments (see Appendix, Figures 7, 8 and 9). The financial industry constantly creates new financial products that make it possible to lower the volatility of interest rates and currencies and the associated potential for currency and interest rate risks to a minimum. One of these capital market tools to minimize risks in the changes shown linked to interest rate are the so called interest rate swaps.

The aim of this work is to explain how interest rate risks can be minimized with interest rate swaps. It will focus on the over the counter (OTC) interest rate swaps market.

In the first chapters this termpaper examine the historical development, basic model, trading platforms and different meaning for lenders and borrowers of interest rate swaps. Next, it will explain the valuation and calculation of interest rate swaps as well as the specific value drivers and approaches. In summary, it provides an overview of the different types of interest rate swaps while also taking a critical look at these derivatives.

2 Basics of interest rate swaps

The interest rate swap involves the agreement of two parties to exchange interest payment flows, which are based on a nominal reference amount which itself is not replaced. In addition, a fixed term of the swap contract between the parties is agreed[5]. In the classic version (‘plain vanilla swap’) fixed interest payments are ‘swapped’ against variable interest payments in the same currency[6]. Here, a contracting party is obliged to pay to the other the current value for the term of the swap rate[7]. These interest payments are made throughout the duration of the swap, regardless of whether the interest rate has changed in the meantime[8]. The other contractors need to pay the base rate over the entire term of the swap related to the current, short-term interest rate. However, it is also possible to not only swap fixed interest rates not only fixed for floating interest rates, but also fixed for fixed and variable against variable. The significance of swaps is that debtors’ long-term borrowing can align calculable costs viewpoints interest moderately because through the use of swaps, the risk of volatile interest rates is limited.[9]

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Figure 1: Interest rate counterparties

2.1 Reference rate and credit rating

Interest rate and credit rating[10]. are corporate value drivers and variables within the calculation and measurement of interest rate swaps.

The reference rate is set by the central banks and is an instrument of monetary policy. The prime rate is the rate at which commercial banks can refinance at the central banks. Commercial banks have to deposit collateral, usually in the form of securities. The securities deposit is also called a repurchase agreement or ‘repo’. Main reference rates used in Germany are the London Interbank Offered Rate (LIBOR), Euro Inter Bank Offered Rate (EURIBOR) and Frankfurt Interbank Offered Rate (FIBOR).

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Figure 2: Current EURIBOR rates


There is a significant statistical correlation between rating (see Appendix, Figures 11) and interest rate structure of debt securities issued in financial markets in the sense that a lower rating and higher insolvency risk of an issuer goes along with a higher return on demand title. Partly also non-public data is taken into account in the rating.

2.2 Net present value (NPV) of interest rate swaps

The market value of an interest rate swap is the NVP of its cash flows. In the NVP method the present value (PV) of the two legs of the swap are compared against each other. The NVP is the difference between the present values of the pay and receive sides:[11]

NPV(swap) = PV(receive) - PV(pay)

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Figure 3: Present value parties

2.3 Equilibrium of interest rate swaps

In a balanced interest rate swap, the interest rate should be chosen so that the PV of Party A is equal to the PV of Party B (see Figure 4).[12]

PV(receive) = PV(pay)[13]

2.4 Sample calculation of an interest rate swap according to Perdion / Steiner

A company and a bank have subsequent starting position in credit financing:

Table 1: Starting Position

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The industrial company has a relatively minor disadvantage in interest rate floating funding compared to the bank in interest rate fixed funding. Nevertheless the industrial company would like to get off the risk of a floating interest rate and therefore prefers a credit at a fixed interest rate. Under a swap transaction, the bank takes over the floating rate funding of industrial enterprise on floating rate notes at EURIBOR + 0.75%. In turn, the industrial company receives from the bank a fixed interest of 8.75%.

Table 2: Interest rate swap advantage

illustration not visible in this excerpt

3 Genesis, classification of interest rate swaps and the need for risk mitigation of interest rates

3.1 Genesis of swaps

In 1980, the first swaps were traded as a hedging instrument[14]. Since then their importance has been growing in the financial world, not only for banks.

The term "swap" comes from English and means "trade-off"[15]. The basic idea of the swap is the application of the theory of comparative advantage of David Ricardo (1772- 1823)[16]. The theory, which originally refers to the exchange of goods in international trade, can be easily transferred to the international financial community. The comparative advantage[17] is largely due to the different credit ratings and market access of each party. Also, the corresponding rating plays an important role. These differences can be used to gain arbitrage.

illustration not visible in this excerpt

Figure 4: Interest rate swaps market development since 1998

The swap market evolved because of the differing needs of its participants. Large European banks could obtain funds relatively cheaply because of their triple-A credit ratings. In particular, they could issue Eurobonds at a relatively low fixed rate cost.

With a volume of 75% of the on the OTC market traded interest rate contracts, interest rate swaps take a dominant role and importance (see Appendix, Figure 10).

3.2 Classification of OTC swaps

Interest and currency swaps are among the group of derivatives, more specifically interest derivatives. Derivatives (lat. Derivare = derived) are products derived from other financial instruments and their prices (for example, stocks, bonds, etc.), and therefore the price of derivatives is also determined by the performance of the underlying securities[18]. The derivatives market consists of exchange-traded and OTC derivatives, the so-called OTC transactions. OTC transactions are financial transactions which are concluded in OTC trading between financial market participants. OTC stands for the English term "Over The Counter". OTC trading is in German referred to as "Tafelgeschäft". Almost all swaps are traded as so-called OTC transactions. A major advantage of OTC transactions arises from the fact that market participants autonomously negotiate the modalities, hence contracts can be adapted to the needs of counterparties. Consequently, OTC products are flexible and thus allow for a wide range of applications.

Interest rate swaps are financial derivatives of the second generation. Derivatives of the second generation are those products, the contractual content of which does not aim at actual delivery of the underlying, but which are directed at a performance dependent on the performance of the underlying cash settlement[19]. That means, at the due date the previously agreed forward price is compared to the current spot price and only the difference depending on the construction of a counterparty belongs (cash-settled variant). Examples are the interest rate swap, the forward rate agreement and interest rate caps (caps, floors).

In the current swap market, the role of the broker has been replaced by a dealer-based market comprised of large commercial and international financial institutions. Unlike brokers, dealers in the OTC market do not charge a commission. Instead, they quote “bid” and “ask” prices at which they stand ready to act as counterparties to their customers in the swap. Because dealers act as middlemen, counterparties need only be concerned with the financial condition of the dealer, and not with the creditworthiness of the other ultimate end user of the swap.[20]

3.3 Special interest rate risks in the lending business

In the lending business, there are a variety of risks that could bring the company either gains or losses. A borrower fails, an IT system fails, a payment cannot be executed or interest rates rise rapidly. Each of these cases represents a different type of risk for a company. In total four major risk categories are distinguished.: the credit risk, liquidity risk, various operational risks and market risk, which include foreign exchange and interest rate risk.

The major risks in the lending business is the interest rate risk. The interest rate risk for fixed-interest agreements provides a problem for credit institutions, if the fixed-interest of a balance sheet item on the assets side (for example, its own investment in the capital market or a loan to the customer due to lending) is shorter than that of refinancing. For credit institutions, the risk of a change in interest rates is also provoked by the fact that variable condition collusion in the lending business is not the same as in funding business to be able to put in refinancing - for example, if a bank makes a loan the interest rate risk is not limited to individual balance sheet items, but affects the entire financial structure of a company. For credit institutions, insurance companies and all other companies active in the money capital markets, interest rate risk is also known as negative differential interest margin, that is, as the difference of all interest income and expenses expected from the understood value.

4 Types of interest rate swaps

Interest rate swaps are important tools of financial engineering. Like other financial tools, they can be used in different capacities and toward different objectives.

The following is a list of parameters that impact the cash flows in swaps:[21]

- Effective date:

The effective date describes the start date of an interest rate swap. A swap can start immediately or sometime in the future. Typically a swap is negotiated on a ‘trade date’, takes effect two days later on its ‘initial settlement date’. Interest begins accruing on the effective date of the swap, which usually coincides with the ‘initial settlement day’.[22]

- Maturity date:

Maturity date is the date on which the principal amount of a swap becomes due and is repaid to the investor and interest payments stop. It is also the termination or due date on which an instalment loan must be paid in full.

- Notional amount:

the principal of the debt the swap is complementing corresponds to the notional amount of a swap. If the principal is fixed the swaps notional amount will be constant. If the of the loans varies, then the notional amount of the swap can also be principal amount.

- Index (basis for comparison like Rating, reference rate):

The index describes the applied information and method for valuing and calculating the swap agreement. This includes e.g. the Underlying specified information for the rating, calculation parameters, key interest rates, used interbank offered rate.

- Rate:

Agreed Swap Rate in %.[23]

- Reset frequency:

If the rate should be adapted within the contract period by changed index-based parameters this will be defined in the contract as the reset frequency.

These parameters describe or define the terms negotiated and are components of a typical swap agreement.[24]

Based on these parameters, the next chapters will give an overview about various interest rate swap options, which are traded in the OTC market. Swap derivates like caps and floors have been omitted.


[1] Cf. Hartnmann-Wendels et. al. (2015). p.267.

[2] Cf. Vanini, U. (2012). p.10.

[3] Cf. Sauter, W. (2010). p.18 f.

[4] Cf. Engels, W. (1976), p. 1264 ff.

[5] Cf. Schmidt. (1999). p. 84 ff.

[6] Cf. Fierbach. (1994). p. 28 ff., Cf. Saber N. (1994). p. 3 f.

[7] Cf. Spender. (1999). p. 12.

[8] Cf. Spremann, K. & Gantenbein, P. (2005). p. 177 ff.

[9] Cf. Perdion, L. & Steiner, M. (1997). p. 307.

[10] Cf. Gabler Wirtschaftslexikon (2016, June 1).

[11] Cf. Saber N. (1994). p. 52 f.

[12] Cf. Saber N. (1994). p. 52 f.

[13] Cf. Perdion, L. & Steiner, M. (1997). p. 309 f.

[14] Cf. Saber N. (1994). p. 3 f.

[15] Cf. Beike, R. / Schlütz, J. ( 1999). p. 261.

[16] Cf. Thiel, T.(1993). p. 12 f.

[17] Cf. Saber N. (1994). p. 3 f.

[18] Cf. Gondring, H. (2004). p. 888.

[19] Cf. Weber, A. (1997), p. 322 ff.

[20] Cf. Skarr. D. (2007). p. 14.

[21] Cf. Saber N. (1994). p. 144 f.

[22] Cf. Saber N. (1994). p. 144 f.

[23] Cf. Skarr. D. (2007). p. 8.

[24] Cf. Saber N. (1994). p. 142 f.

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Interest Rate Swap. A vehicle to hedge against interest rate risk
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Patrick Haug (Author), 2016, Interest Rate Swap. A vehicle to hedge against interest rate risk, Munich, GRIN Verlag,


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