In an interest rate swap, two parties will agree to: term, fixed rate, floating rate benchmark (commonly LIBOR), notional principal, and payment frequency.
The notional principal is not exchanged; rather it is used to calculate coupon payments.
“Plain vanilla interest rate swap” specifically refers to a fixed-floating agreement; the term “interest rate swap” may refer to plain vanilla or other variations.
As you can see in the above diagram, Party A is paying floating rate on its obligation, but wants to pay fixed rate. Party B is paying fixed rate, but wants to pay floating rate. They can enter into an interest rate swap, and the net result will be that each party can ‘swap’ their existing obligation for their desired obligation.
A common practice for swap agreements is that the floating rate is set in advance (at contract initiation and immediately following subsequent payment/reset dates) and paid in arrears (the coupon period precedes the actual payment).
- Because both the fixed and floating rate are known at initiation, both parties will know who has the larger payment on the first payment date.
- The parties can agree to payment netting, where the party with the larger payment simply pays the other party the difference.
- Fixed Payment = (Fixed Rate/Coupons per year) * Notional Principal
- Floating Payment = (Floating Rate/Coupons per year) * Notional Principal)
- Example: Notional equals $1 million. At initiation, the fixed rate is 5% and the floating rate is 4%. The parties have agreed that payment intervals are six months. Thus, at the end of six months, the fixed rate payer/floating rate receiver will owe $50,000 and the floating rate payer/fixed rate receiver will owe $40,000. A net payment of $10,000 can be made by the fixed rate payer to the fixed rate receiver.
A common motivation for entering into an interest rate swap is that an investor or a company wants to alter its interest rate exposure to better match its assets and liabilities.
Example: A borrower is locked into fixed rate debt and anticipates that interest rates will fall. The borrower can enter a swap as the floating rate payer/fixed rate receiver. By receiving a fixed rate, the borrower’s debt is offset and if interest rates fall as anticipated then the floating rate payment on the swap will be lower than the fixed rate payment on the debt. In a situation such as this the notional principal of the swap will need to equal the amount of the borrower’s debt.