interest rate swap
Example of a basic interest rate swap
A company wishes to issue debt and has been advised that the cost will be lower if it issues floating (rather than fixed) rate debt because e.g. investors are expecting future interest rate rise and willing to take a lower spread on the coupon. The company could issue the floating rate debt and swaps to a fixed rate. It does this by entering into an interest rate swap with a swap counterparty (usually an investment bank).
Under the interest rate swap, the company will agree to pay the swap counterparty a fixed amount in exchange for a floating amount from the swap counterparty.
The fixed amount calculated by the company will be calculated by reference to a ‘notional amount’ (which corresponds with the principal amount of the debt issued by the company in our example) and a fixed rate.
The floating amount payable by the swap counterparty will be based on the same notional amount and based on a floating rate (e.g. LIBOR, the London interbank offered rate) and will corresponds with the interest amount payable by the company on the debt issued.
The fixed and floating amounts may also be calculated by reference to, inter alia, “day count fraction”, “designated maturity”, “calculation period” as defined in the 2000 and 2006 ISDA definitions.
To see an illustration by ISDA please click here.
selected further reading
Understanding interest rate swap math & pricing.
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Last updated June 2007
^The above notes are intended to highlight issues and provide only general outlines and not intended to be comprehensive nor legal advice. Where applicable, the same should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They shall never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation in reliance thereof. If you have any question, please contact us.
