Term
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Definition
Arrangements whereby one party exchanges one set of interest payments with another
party -- generally, fixed-interest rate payments are exchanged for floating rate interest
payments over time. This is often done to effect a firm's GAP without the firm having to
make any changes in its assets or liabilities. A firm with expectations of rising interest rates
will want to increase its interest sensitive assets in its asset portfolio and decrease the
non-interest sensitive assets. This will allow the firm to invest cash inflows in continually
higher yielding assets. Alternatively, from the perspective of the right hand side of the balance
sheet, the firm will want to lock in what are now low cost funds by exchanging its interest
sensitive funds for the non-interest sensitive funds of a contra party. |
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Term
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Definition
One very important reason for the evolution of interest rate swaps is to allow financial institutions
to effect their GAP without making permanent (semi) adjustments in their asset or debt portfolios.
For example, if a bank forecasts that interest rates are going to increase and it wants to take advantage of the expected increase, it can increase its GAP ratio by engaging in swap transactions. |
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Term
| Provisions of an Interest Rate Swap |
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Definition
The notional principal value to which the interest rates are applied to determine the interest payments involved.
The fixed interest rate
The formula and type of index used to determine the floating rate.
The frequency of payments; annually or semi-annually.
The lifetime of the swap. |
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Term
| Financial Institution Participation |
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Definition
To reduce interest rate risk
In the function of an intermediary; matching up firms and facilitating swap arrangement and, perhaps, acting as a credit guarantor. This is done for a fee.
Acting as a dealer; i.e. taking the contra position to serve a client. |
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Term
| Types of Interest Rate Swaps: Plain vanilla swap |
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Definition
| exchanging fixed rate for variable rate, or vice versa |
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Term
| Types of Interest Rate Swaps: Forward swap-- |
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Definition
| while the contract is made "today" the interest payments are exchanged |
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Term
| Types of Interest Rate Swaps: Callable swap-- |
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Definition
| the party making the fixed payments is provided the right to terminate the |
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Term
| Risks of Interest Rate Swaps: Credit Risk-- |
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Definition
| the risk that a firm involved in a swap will not meet its payment obligation |
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Term
| Risks of Interest Rate Swaps: Sovereign Risk- |
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Definition
| the risk of potential adverse effects resulting from a country's political |
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Term
| Pricing of Interest Rate Swaps: Primary Determinants |
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Definition
prevailing market interest rates
availability of counter-parties
credit and sovereign risk |
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Term
| Interest Rate Swaps Summary |
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Definition
We can manage our GAP without making any transactions on our
portfolio. One way to do this is through the use of Interest Rate
Swaps, the exchange of interest rate obligations ( or expected interest
income). If we forecast and act accordingly, and our forecast proves
correct, we will win; if we forecast and act accordingly, and our
forecast proves to be wrong, we lose. |
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