What are the basic forms of interest rate swaps?

2023-06-15
Summary:

An interest rate swap is a financial derivative that refers to the exchange between two different interest rates. There are several basic forms of interest rate swaps, and investors can design different forms based on different needs and market conditions.

Interest rates can take various forms, and any two different forms can be converted to each other through interest rate swaps. There are three main types of interest rate swaps: coupon swaps, base swaps, and cross-currency interest rate swaps.

interest rate swap

1. Couponswap

A coupon swap is a swap between fixed and floating rates of the same currency in which one party pays a series of fixed-rate interest payments to the other party in exchange for a series of floating-rate interest payments paid by the other party. From the perspective of the counterparty, it is to pay a series of floating interest rate interest payments in exchange for a series of fixed interest rate interest payments. This is the most basic and common trading method in interest rate swaps, and both parties do not exchange cash flows for principal. Most coupon swaps are denominated in US dollars, while small coupon swaps are also denominated in British pounds, Swiss francs, Deutsche Mark, Japanese yen, and other currencies, but this situation is rare.


2. Basic Swap

A basic interest rate swap is an interest swap between floating interest rates of the same currency based on different reference interest rates and floating interest rates; that is, a floating interest rate swap of one reference interest rate is exchanged for a floating interest rate of another reference interest rate. In a basic interest rate swap transaction, both parties pay and receive interest payments at two different floating rates. The interest amount of both floating interest rates is calculated based on the same amount of nominal principal. For example, the three-month USD Libor is used to calculate the US commercial paper hybrid interest rate. Basic swaps account for over one tenth of the swap market share, and there is still relative growth at present. The vast majority of basic swaps are used by traders who have already entered into two types of coupon exchanges.


3. Cross-currency interest rate swap

A cross-currency interest rate swap is a swap of different interest rates for different currencies, that is, the exchange of a fixed interest rate of one currency with a floating interest rate of another currency. In other words, in a swap transaction, there is an exchange of different currencies (such as the Japanese yen against the US dollar) and different interest rates (such as a fixed interest rate against a floating interest rate). The most typical example of this type of exchange is the exchange of US dollar floating interest rates with non-US dollar fixed interest rates, such as the 3-month exchange of US dollar floating interest rates with fixed interest rates in Japanese yen. Some traders view this arrangement as a single transaction, while others differentiate between the composition of cross-currency and interest rates. This type of swap began in the European capital market in 1984 and is also known as the 'reverse belly-breaking' swap transaction.

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