This is the first in our interest rate swap tutorial; a series of articles that will go from the basics about interest rate swaps, to how to value them and how to build a zero curve.
Introduction: Interest Rate Swap Tutorial
An interest rate swap is where one entity exchanges payment(s) in change for a different type of payment(s) from another entity. Typically, one party exchanges a series of fixed coupons for a series of floating coupons based on an index, in what is known as a vanilla interest rate swap.
The components of a typical interest rate swap would be defined in the swap confirmation which is a document that is used to contractually outline the agreement between the two parties. The components defined in this agreement would be:
Notional – The fixed and floating coupons are paid out based on what is known as the notional principal or just notional. If you were hedging a loan with $1 million principal with a swap, then the swap would have a notional of $1 million as well. Generally the notional is never exchanged and is only used for calculating cashflow amounts.
Fixed Rate – This is the rate that will be used to calculate payments made by the fixed payer. This stream of payments is known as the fixed leg of the swap
Coupon Frequency – This is how often coupons would be exchanged between the two parties, common frequencies are annual, semi-annual, quarterly and monthly though others are used such as based on future expiry dates or every 28 days. In a vanilla swap the floating and fixed coupons would have the same frequency but it is possible for the streams to have different frequencies.
Business Day Convention – This defines how coupon dates are adjusted for weekends and holidays. Typical conventions are Following Business Day and Modified Following. These conventions are described in detail here.
Floating Index – This defines which index is used for setting the floating coupons. The most common index would be LIBOR. The term of the index will often match the frequency of the coupons. For example, 3 month LIBOR would be paid Quarterly while 6 month LIBOR would be paid Semi-Annually.
Daycount conventions – These are used for calculating the portions of the year when calculating coupon amounts. We’ll explore these in more detail in our discussions on fixed and floating legs. Details of different daycounts can be found here.
Effective Date – This is the start date of a swap and when interest will start accruing on the first coupon.
Maturity Date – The date of the last coupon and when the obligations between the two parties end.
Thanks to our sister company Resolution for providing us with this series of posts.
Next Article: Constructing fixed legs including calculating coupon amounts.