Interest Rate Swaps

IRS are OTC agreements between two counterparties to exchange or swap CFs in the future.

 

A plain vanilla IRS is one in which two parties swap a fixed rate of interest and a floating rate. In an IRS, the notional is the principal amount that is used to compute interest percentages, but this sum will not actually change hands. Payments are netted, because all CFs are in the same currency.

The payer on the swap is the person who agrees to pay the fixed rate and expects the IR to rise. He is long the swap. The receiver is the person who agrees to receive the fixed rate. The receiver expects interest rates to fall and is short the swap.

 

A basis swap is an IRS where a floating rate is swapped for a different floating rate.

 

To compute the value of a swap, one should calculate the NPV of all future CFs, which is equal to the PV from the receiving leg minus the PV from the paying leg. Initially, the terms of a swap contract are defined in such a way that its value is null.  

 

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