Interest Rate Swap

An interest rate swap agreement is a contract between two parties to exchange interest (coupon) payments on a specified notional principal amount for a specific term. No principal is exchanged only interest flows. In a generic interest rate swap one party pays fixed and the other party pays floating. This exchange allows for conversion of variable rate funding to fixed rate exposure or fixed rate funding to variable rate exposure. The fixed swap rate is a market rate that approximates investment grade fixed rate borrowing levels. The floating rate is a short-term market rate based on a specific money market index (i.e., LIBOR).
Exchange of payments occurs at preset payment dates over a specified term (i.e., semi-annual payments for five years). Exchanges reflect differences between the fixed rate and each period's floating rate. The calculation or determination of the floating rate depends
upon its underlying index (i.e., LIBOR, Commercial Paper, Prime, etc.) and the specific terms of the transaction (discrete setting or average). For example, LIBOR based swaps are normally discrete setting (LIBOR set at the beginning of the period), and Commercial Paper and Prime swaps are normally averaged (Set at the end of the period based on the average of the underlying index during the period.) The fixed and floating payments usually are netted and the counterparty owing the difference pays the net amount on the payment date.
Swaps resemble non-callable fixed rate debt and their value is completely determined by market conditions. If a party is paying fixed and interest rates increase, the value of the swap increases to the fixed rate payer. An interest rate swap can be terminated at any time with the consent of both parties and the termination amount (Market value) will depend on the relationship between the fixed rate on the swap and current market rates. If a party is paying fixed and interest rates decline, that party has to pay to terminate the swap. Conversely, if a counterparty is paying fixed and interest rates rise, that party receives the market value upon termination.
Parties to an interest rate swap take on potential credit exposure to one another. At BNY formal credit approval is required before entering into a transaction with a counterparty.
EXAMPLES OF PAYMENT FLOWS If fixed rate = floating rate, there is no swap payment If fixed rate > floating rate, the fixed rate payer pays the net amount If fixed rate notional principal x (fixed rate x interest days/day basis - floating rate x interest days/day basis)
TYPICAL CHARACTERISTICS

Start date: Spot or forward
Term: Up to 10 years
Payment Frequency: Annually, Semi-Annually, Quarterly, or Monthly
Day Count: 30/360, Actual/360, or Actual/365
Structure: Bullet, Amortizing, Accreting, or Zero-Coupon
Floating Rate Index: LIBOR, Prime, Commercial Paper, or T-Bill

TYPICAL SWAP APPLICATIONS
Liability Management

Situation 1: A large corporate borrower's debt structure is 50% fixed and 50% floating. Interest rates are rising and the corporation wants to change its fixed/floating mix from 50/50 to 75% fixed and 25% floating.
Solution: The corporation could pay off some of its floating rate debt and issue or borrow additional fixed rate debt. However, this process could be onerous and the transaction costs could be high. A simpler and less costly process is to enter into an interest rate swap. The borrower could swap its floating rate exposure (LIBOR, Prime, Commercial Paper, T-Bill) for a fixed rate exposure.
Situation 2: A corporation with access to the public debt market wants to borrow additional funds and maintain a ratio of 50% fixed and 50% floating debt. The investor community seeks fixed rate investments.
Solution: Investor demand gives the borrower a comparative advantage in the fixed rate public debt market. The corporation proceeds with a fixed rate public debt issue, and swaps half the issue to floating to maintain the 50/50 debt structure.
Situation 3: A corporation with access to the public debt market wants to borrow additional funds and maintain a ratio of 50% fixed and 50% floating debt. The investor community is concerned that rates will be rising and is seeking floating rate investments.
Solution: Investor demand gives the borrower a comparative advantage in the floating rate public debt market. The corporation proceeds with a floating rate public debt issue, and swaps half the issue to fixed to maintain the 50/50 debt structure.
Situation 4: A small regional bank has seen an increase in loan demand. The loans are for two and three years priced at Prime. The bank funded the loans initially by purchasing Fed Funds but is concerned about a potential liquidity problem if their lenders stop selling Fed Funds to them.
Solution: The bank issues a three year bank note and swaps it to a spread under Prime. These transactions will eliminate the liquidity risk, and the interest rate risk between Fed Funds and Prime.
Situation 5: Two companies formed a joint venture to build a plant. The plant will be funded by bank debt. Interest rates are likely to rise and higher interest rates would threaten the project's economics. Construction is not scheduled for three months and completion will take twelve months.
Solution: The joint venture fixes the rate on the bank debt through a forward starting roller coaster interest rate swap. The notional principal of the swap accretes with drawdowns under the construction loan and amortizes with the term loan repayment schedule.