Swaps

Interest Rate Swaps

A swap is an agreement between two counterparties to exchange cash or securities over a given time period at typically uniform intervals. The securities characteristically can be quite varied and it is this flexibility that makes swaps so popular in markets. An interest rate swap is simply an agreement between counterparties to exchange a series of interest payments without a corresponding exchange of the underlying debt. In a standard fixed for floating rate swap, the counterparty A promises to pay counterparty B at designated intervals at predetermined fixed interest rate on a "notional principal"; B promises to pay A at the same intervals a floating amount of interest on the same notional principle calculated according to a floating-rate benchmark (often LIBOR but new benchmarks are being sought). A is referred to as the fixed-rate payer and B who pays the floating amount of interest, is known as the floating-rate payer' Interest rate swaps are voluntary market transactions by two parties. In an interest swap, it is logical to presume that both parties extract some economic benefits. It is also common to assume that a swap is a fair game. The economic benefits of interest rate swaps can be related to the principle of comparative advantage. This well developed and widely understood concept was coined by David Ricardo when explaining a key rationale for engaging in international trade.