IRSs: Interest rate swaps

• A plain vanilla IRS is an agreement between two parties to exchange

fixed interest rate payments for floating interest rate payments, in the
same currency, with reference to a notional principal amount which is
usually not exchanged. The buyer of the swap exchanges fixed rate
payments for floating rate payments (so becoming long in floating and
short in fixed rate). The other party (swap seller) agrees to become fixed
rate receiver and floating rate payer (becoming long in fixed and short
in floating rate).
• Purpose of IRSs: to transform a fixed rate asset or liability into a
floating rate asset or liability and vice versa. The floating rate used in
most IRSs is calculated with reference to Libor; if it is Libor itself (no
margin above or below) the swap is known as a Libor flat swap.

• Example of the cash flows for a company that has bought (pay fixed
and receive floating) a 100 million euro 3 year IRS from a Swap Bank
(Hull, p. 123):
Floating Fixed cash Net cash
Date Libor cash flow flow paid flow
received
March 1, 1999 4.20
September 1, 1999 4.80 +2.10 -2.50 -0.40
March 1, 2000 5.30 +2.40 -2.50 -0.10
September 1, 2000 5.50 +2.65 -2.50 +0.15
March 1, 2001 5.60 +2.75 -2.50 +0.25
September 1, 2001 5.90 +2.80 -2.50 +0.30
March 1, 2002 6.40 +2.95 -2.50 +0.45
Note that the first payment (on the 1stsept. 1999) is known at the time the
swap is entered into: it is as if, on the 1st march 1999, the company has
agreed to give the swap seller 0.40 million euro.
• Entering into the swap, the company becomes long floating and
short fixed. In fact, the IRS can be regarded as the exchange of a
fixed rate bond for a floating rate bond. The fact that the principals
are not exchanged does not modify the net cash flows.

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• Swaps can be used to transform assets and liabilities from fixed to
floating rate and vice versa.
Example 1: Bank A has a fixed rate asset and wants to transform it into a
floating rate. Hence it buys a swap:
Bank A receives from its asset 4.80%
pays to a Swap Bank 4.85%
receives from the Swap Bank Libor
so succeeding in transforming an asset yielding 4.80% into one with a net
yield of Libor - 5 bps.
Example 2: Company B has a floating rate loan and wants to transform it
into a fixed rate loan. For the floating rate loan the Company now pays
Libor + 100 bps. Entering into (buying) the swap:
Company B pays to a Swap Bank 4.80%
receives from the Swap Bank Libor
pays for the existing loan Libor + 100 bps
Hence it ends up with a fixed rate loan at 5.80%.

• Valuation of IRSs. For a swap buyer who receives (is long) floating and
pays (is short) fixed, the value of the swap is given by the difference
between the values of the two bonds:
V = B float − B fix
valuated at the appropriate spot yield. The fixed rate is usually chosen so
as to have V = 0 at the start of the swap.

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Example: Consider a 100 euro 3 year swap with annual payments. Today
the structure of interest rates is:

Date spot rates forward

1 5.00 5.00
2 5.13 5.26
3 5.40 5.94

For the 3 year swap, the present value of the cash flows of the expected
floating rates (which are the forward rates) is:
5.00 5.26 5.94
+ +
( 1 + 0.05) ( 1 + 0.0513 ) ( 1 + 0.054 ) 3
2
= 14 .59409 Let X be the unknown fixed rate
cash flows. To have the same present value of the floating rate cash flows,
it should be:
X X X
+ + = 14 .59409
( 1 + 0.05) ( 1 + 0.0513 ) ( 1 + 0.054 ) 3
2

By solving we get X = 5.3828707≈ 5.383 which is known as the swap rate for
a 3-year maturity. The value of a 3 year fixed rate bond that pays:
5.383% should be equal to the present value of the interest cash flows
plus the present value of the principal. Hence, it should be:
100
14 .59409 + = 14 .59409 + 85.4040 =
( 1 + 0.054 ) 3
= 99 .9981 ≈ 100 = B fix
5.00 + 100
and, for a floating rate bond, it is: B float = = 100
( 1 + 0.05)

Hence V = 0 at the start of the swap.

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Footnote
In recent times in Italy a controversy arose on the utilization of swaps
by some Municipalities and Regions. It seems that these institutions have
performed swap operations in order to receive immediately an amount of
finance to be repaid later. How could it happen? One possibility is the
following. A Municipality accepts to pay for a swap a fix rate higher than
the swap rate, say by 2% (7.383% instead of 5.383%). Hence, the initial
value of the swap is negative for the Municipality that is compensated by
an upfront payment for the difference.
Calculation:
7.383 7.383 7.383
+ + =
(1 + 0.05 ) (1 + 0.0513 ) (1 + 0.054 ) 3
2

= 20 .01686
100
B fix = 20 .01686 + = 105 .4209 Hence the Municipality can receive an
(1 + 0.054 ) 3
upfront payment of 5.4209% of the notional amount of the swap. Of
course, the operation is not a plain vanilla swap; a loan has been actually
added!
If the Municipality had agreed to pay the float rate plus 2% and to
receive the fix 5.383%, the calculation of the upfront payment would be:
2 2
B float = 100 + + +
(1 + 0.05 ) (1 + 0.0513 ) 2
2
+ = 105 .4224
(1 + 0.054 ) 3
Now, suppose that at t = 0.5 the structure of interest rates has
become:

Date spot rates forward

0.5 5.25 5.25
1.5 5.50 5.625
2.5 5.75 6.125

The swap now last for 2.5 years. The values of the fixed and the floating
rate bonds are given by:
5.383 5.383 105 .383
B fix = + + ≈
( 1 + 0.0525 ) 0 .5
( 1 + 0.055 ) 1.5
( 1 + 0.0575 ) 2.5
≈ 101.85
105
B float = ≈ 102 .35
( 1 + 0.0525 )
0 .5

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so that: V = B float − B fix = 102 .35 − 101.85 = 0.50

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 Fixed-rate currency swaps
• Currency swaps are agreements to exchange payments in one currency
for payments in another. The principals are usually exchanged, as well
as the interest payments.
• Fixed-rate currency swaps have 3 main components: the principals, the
exchange rate and two fixed interest rates. At the beginning of the swap
the principals are exchanged at an agreed exchange rate, usually the spot
rate. At the maturity, the principals are re-exchanged at the initial
exchange rate (in the case of the par swaps that we shall now consider;
with an outright swap instead, the re-exchange is made at the forward
exchange rate implied by the covered interest rate parity prevailing at the
beginning of the deal).

• Fixed-rate currency swaps allow to transform (for instance) a fixed rate

liability in one currency into a fully hedged fixed rate liability in another
currency.
• Example: Let the spot exchange rate be $1 = 1Euro. Suppose that

Company A (European) and Company B (American) can borrow at

these rates:
A B
Fixed rate Euro loans 6% 7%
Fixed rate dollar loans 6% 5%
A has a comparative advantage in raising fixed-rate Euro finance and B
has one in raising dollar finance. If A prefers to have a dollar loan and B
an Euro loan, a swap can be arranged with a Swap Bank. One possibility is
the following:

euro6% Company A euro 6.5% Swap Bank euro 6.75% Company B $5.00%
$ 5.75% $5.50%

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Company A: Borrows fixed rate euro at 6.00%
Receives from the swap euro at 6.50%
Pays for the swap $ at 5.75%
So Company A effectively borrows fixed-rate dollars at 5.25%, i.e. at
0.75% less than if it had borrowed dollars at 6.00%.
Company B: Borrows fixed-rate dollars at 5.00%
Receives from the swap dollars at 5.50%
Pays for the swap euro at 6.75%
So Company B effectively borrows euro at 6.25%, i.e. at 0.75% less than
if it had borrowed euro at 7.00%.
Swap Bank makes 0.50% out of the deal.
• If the swap is for 100 million euro and 100 million $, Company A will

save Euro 750,000 and Company B will save $ 750,000 for each year
that the swap is in place.

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 Banks’ hedging against mismatching by using swaps
Income risk

• If a bank has a positive Gap, it can protect its interest margin by selling
swaps. Let the gap be 10 millions euro. By selling a swap on 10 mln
euro, our bank becomes a fixed rate receiver and floating rate payer, so
transforming 10 mln of its assets from floating to fixed.

• Pre-swap situation. Party A (bank) receives from its floating rate loans
i6 +50bp and pays to depositors 5.80% fixed. So it will lose if i6 falls to
5.30% or less. Party B (insurance company) receives from its fixed rate
investments 6.70% and has to pay i6 +40 bp for a mortgage. It will lose
if i6 goes above 6.30%. Both A and B aim at fixing a constant spread
between the rate they receive and that they pay.

• Swap: A agrees to pay the floating rate on 6 months BOT plus a spread
of 35 bp. B agrees to pay 6.3% fixed rate.

i + 35bp i + 30bp

6
→ 
6
→
Part A
Swap Part B
6 .3 0 % 6 .3 0 %
←   ←  
bank

The fees of the swap bank amount to 5 bp

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A: receipts: from the loans = i6 + 50
from the swap = 6.30%
total = 6.80% + i6
payments for the swap = i6 + 35
to depositors = 5.80%
total = 6.15% + i6 ∆ = 65bp

B: receipts from investments = 6.70%

from the swap = i6 + 30
total = 7.00% + i6
payments for the mortgage = i6 + 40
for the swap = 6.30%
total = 6.70% + i6 ∆ = 30bp

• In the case of parallel shifts, if a bank wants to hedge the interest margin
for the next 12 months with a swap of the same maturity, it has to enter
into a swap contract for a notional value equal to the Gap position with,
of course, the sign changed: Gap>0 ⇒ sell swaps (viceversa for Gap<0).

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 Hedging the net worth with swaps

• For a full hedge of a bank’s net worth, the relation to satisfy is:
∆ NW = − ∆ S where ∆S is the change in the value of the swap positions.
Remember that at t = 0 the value of a swap is zero. At t = 0 + ε ,with a
parallel shift in the TSIR, the changes in the bank’s net worth and in the
value of a swap of a notional value NV S are given by:
∆NW = − DG A∆i
( ) ( )
∆S = NV S ∆B float − ∆B fix = NV S − D float + D fix ∆i
where D and D are the modified durations of the floating and the
float fix

fixed leg of the swap. By solving the hedge relation, we obtain:

DG A
NV S =
D fix − D float
so that:
• DG > 0 ⇒ NVS > 0 ⇒ buy swaps, becoming fix rate payer and floating rate
receiver.
• DG < 0 ⇒ NVS < 0 ⇒ sell swaps, becoming floating rate payer and fix rate
receiver

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 Appendix 1

Evaluation of currency swaps: example

In the past a company entered into a currency par swap

(without any intervention of a swap bank). At that time, the
exchange rate (which is also the rate to be applied at the settlement

date) was: r = 1.10 $ = 1

€. The TSIR was flat both in the US and in
the EU area. Under the term of the swap, the company receives
$ at 5.50% and pays € at 4.50% with annual payments.
It is like as the company is long a $ bond and short a € bond. The
notional value is 1 mill. € (= 1.1 mill. $) so that the
company cashes 60,500$ per year and pays 45,000€ per year.

Exactly 2 years before maturity, the TSIR is once again flat

both in the US and in the euro area. The prevailing rates are:
i$ = 5.50% i€ = 4.00%

Denote by B$ the value of the $ denominated bond and by B€

the value of the € denominated bond.
60 ,500 1,160 ,500
B$ = + =1,100 ,000 $
(1.055 ) (1.055 ) 2
45 ,000 1,045 ,000
B€ = + = 1,009 ,430 €
(1.04 ) (1.04 ) 2

Hence, the value of the swap in € is:

1,100 ,000
VS = −1,009 ,430 = −9,430 €
1.1

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