Rashedul Hasan

• In finance, a swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap.
• Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. In most common cases, fixed rate interest payments are exchanged for floating rate interest rate payment over time. The provisions of an interest rate swap include,

• The notional principal value to which the interest rates are applied to determine the interest payment
• The fixed interest rate
• The foemula and Type of index used to determine the floating rate
• The frequency of payments, such as every 3 months, 6 months etc.
• The lifetime of the swap.

• For example, Financial institutions such commercial banks in U.S. traditional had more interest rate sensitive liabilities than assetsa and therefore can adversily affected by increasing interest rate. On the other hand, some financal institutions in Europe, had funds primarily for floaing-rate loan. These institutions are adversly affected by declining interest rate.
• By engaging in interest rate swap, both type of financial institutions could reduce their their expouser to inteest rate risk. The U.S. financial institutions could send fixed rate interest payments to a European financial institution in exchange for floating rate payments.

Although, U.S. financial institutions foregoes the potential benefits from decline in interest rate, while the European financial institutions foregoes the potential benefits from increase in interest rate. The interest rate swap enables each institutions to offset any gains or losses that result specifically from interest rate movement.

The first swaps were negotiated in the early
1980s. David Swensen, a Yale Ph.D. at
Salomon Brothers, engineered the first swap transaction according to "When Genius
Failed: The Rise and Fall of Long-Term
Capital Management" by Roger Lowenstein.
Today, swaps are among the most heavily traded financial contracts in the world.

Most swaps are traded over-the-counter (OTC),
"tailor-made" for the counterparties. Swap is less standardized than other derivative instruments such as Future or Option. Therefore, Telecommunication network is more prefarrable than a physical exchange for the swap trade. Some types of swaps are also exchanged on futures markets such as the
Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board
Options Exchange, IntercontinentalExchange and
Frankfurt-based Eurex AG.

• Plain Vanilla swap
It is also known as fixed-for-floating swap. Here fixed rate payments are periodically exchanged for floating rate payments.
•
Forward swap
It involves an exchange of interest payments that does not begin until a specified future point of time. It is useful for firms, that expect to exposed to interest rate risk at a future point in time.

•
Callable swap
It provides the party making the fixed payments with the right to terminate the swap prior to its maturity.
•
Putable swap
It allows the party making the floating rate payments with the right to terminate the swap prior to its maturity.
• Extendable swap
It allows the fixed-for-floating party to extend the swap period.

Zero coupons for floating swap
Here the fixed rate payer makes a single payment at the maturity date of the swap agreement, while the floating rate payer makes periodic payments throughout the swap period.

•
Interest rate Caps
An Interest rate Cap offers payment when a specified interest rate index exceeds the interest rate ceiling (cap) and therefore can hedge against rising interest rate. The lifetime of a cap is commonly between 3 to 8 years. The typical buyer of an interest rate cap is the financial institution that is adversely affected by rising interest rate. If interest rate rise the payment received from the interest rate cap agreement will help offset any adverse affect. The seller of the interest rate cap receives the fee paid up-front.

• Interest rate Collars
An Interest rate Collar involves the purchase of an interest rate cap and the simultaneous sale of interest rate floor. In its simplest form, the fees received up-front from selling the interest rate floor to one party can be used to pay the fees for purchasing the interest rate cap from another party. Any financial institution that desires to hedge against the possibility of rising interest rate can buy an Interest rate Collar.

Financial institutions
Commercial Banks
Participation in SWAP market
•Engage in swaps to reduce interest rate risk
•Serve as an intermediary by matching up two parties in swap
Serve as a dealer by taking the counter party position to accommodate a party that desires to engage in swap.
Engage in swaps to reduce interest rate risk Savings Institutions, Loan associations and Savings Bank
Finance Company Engage in swaps to reduce interest rate risk
Securities firms
Insurance company
•Serve as an intermediary by matching up two parties in swap
Serve as a dealer by taking the counter party position to accommodate a party that desires to engage in swap.
Engage in swaps to reduce interest rate risk
Pension funds Engage in swaps to reduce interest rate risk