RDP 9409: Default Risk and Derivatives: An Empirical Analysis of Bilateral Netting 2. Interest Rate Swaps

An interest rate swap is an agreement to exchange (swap) interest payment streams of differing characteristics denominated in the same currency. The interest payments are calculated by reference to an agreed amount of notional principal, although at no time is this amount exchanged between the counterparties.

By way of example, consider a company which has an existing borrowing of $10 million where the interest rate payable is set at the bank bill rate at the beginning of each quarter. The company would prefer a fixed rate loan. By entering into a fixed-for-floating swap with a bank, the company can effectively set a fixed rate on its loan. Under the swap agreement the company will pay a fixed 12 per cent and receive the bank bill rate each calculated on a nominal principal of $10 million. The fixed rate is termed the “swap rate”. The combination of the loan and the swap results in the company paying 12 per cent and receiving the bank bill rate on the swap, and paying the bank bill rate on the loan, thereby giving a 12 per cent fixed rate. Figure 1 illustrates the company's interest payments, the broken line representing the original loan and the solid lines the swap cash flows.

Figure 1: A Fixed-for-Floating Swap

The portfolios on which our results are based include both interest rate swaps and forward rate agreements (FRA). FRAs are cash-settled forward contracts on interest rates. On the settlement date of an FRA the difference between two interest payments is exchanged between the FRA counterparties. The first interest payment is determined by a fixed interest rate agreed between the two parties at the inception of the FRA. The second payment is set with reference to a floating rate observed in the market on the FRA's settlement date. An FRA can be treated as a one period swap. Hence the discussion of the credit risk on swap contracts in subsequent sections applies equally to FRAs.