Interest Rates Swap: Key Calculations, Reporting, and its Application as a Popular Investment Product by Mr. Nidhish Singh (ACCA)

Interest Rates Swap: Key Calculations, Reporting, and its Application as a Popular Investment Product by Mr. Nidhish Singh (ACCA)

This article will cover the key components of IRS, how its accounting & reporting is performed and its use as a dominant investment product. This will also cover critical financial and risk management concepts considered while IRS is used in any investment portfolio.

Overview of Interest Rate Swaps

By definition, an Interest Rate Swap is an agreement between two parties (also known as “counterparties”). The counterparties agree to swap or exchange the payments based on a defined principal amount, for a fixed period of time.

In a typical interest rate swap, the principal amount is not, in reality, exchanged between the counterparties, rather, interest payments are exchanged based on a “notional amount” or “notional principal”.

Each counterparty agrees to pay to each other or swap either a “fixed” or “floating” rate – floating can be any variable rate such as LIBOR. As mentioned above the notional amount is not exchanged between counterparties, but is used only for calculating the size of the cashflows to be exchanged at each payment date.

In a swap agreement, the fixed leg of the swap is the leg which is sensitive to changes in interest rates as it can be considered as a fixed rate bond and does not respond to the changes in the market. Hence, the fixed leg is impacted by the market movement. The offsetting floating leg is typically insensitive to changes in interest rates as this one which reflects the changes in the market.

Market Size

As per Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC (“Over The Counter”) derivative market, amounting to 60% of the market. Currently, the open notional value of all IRS contract is USD 540 – which is 7 times of the world’s GDP and 25 times of US GDP.

Key Terms

Notional Amount

This is the principal amount of the swap. It is not exchanged between counterparties and is used for calculating the interest amounts.

Fixed Leg

One counterparty pays a fixed rate throughout the term of the swap agreement, this rate never changes. This counterparty is known as the Fixed Rate Payer.

Floating Leg

One counterparty pays a floating rate throughout the term of the swap agreement which could be settled monthly/quarterly/semiannually or annually, according to the interest-rate index of the swap. For example, the floating rate on a swap indexed to the three-month Libor would normally reset every three months with payment dates following three months later.

Day Count Convention

This lays down the methodology on how the interest payments are to calculated eg 30/360 or A/365. (Note: see Fixed Income Course for further detail).

Trade Date

The day the swap agreement was actually negotiated/traded.

Settlement Date

The date that the swap takes effect, normally two days after the trade date.

Effective Date

This is the date that interest begins accruing and normally coincides with the Settlement Date.

Termination Date

The date on which the swap ends and will be the last date that interest payments are exchanged. This is an important piece of data when calculating the value of a swap.

Payment Netting

When the fixed and floating payments occur on the same date it is normal that the two amounts are netted and whichever counterparty owes the difference pays that amount to the other counterparty.

Uses

Interest Rate Swaps are generally used to hedge against or speculate on changes in interest rates.

Hedging

Interest Rate Swaps swaps are often used by funds to manage or minimise their exposure to interest-rate volatility, by exchanging fixed-rate obligations for floating-rate obligations, and vice versa. By swapping interest rates, a firm hedge or manage within certain limit its interest rate exposures, consistent with the fund’s Investment Policies.

They are commonly used by debt issuers to convert their interest payments, for example, a corporation which issues floating rate bonds may wish instead to pay a fixed rate to enable financial planning.

Speculation

Interest Rate Swaps are used speculatively by hedge funds who expect a change in interest rates or the relationships between them. Traditionally, fixed income funds who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today these funds with a similar view could enter a floating-for-fixed interest rate swap: as rates fall, the funds would pay a lower floating rate in exchange for the same fixed rate.

Leverage

Interest Rate Swaps enable hedge funds to leverage their exposure. If they want exposure to a particular rate of interest/issue (eg US 10 Year Treasury Note), they can enter into a swap where they would receive a fixed rate the same as the current 10-year note in issue and pay floating. All without having to allocate any cash.

A similar result can be obtained by entering into a repurchase agreement, whereby the fund would buy the 10 year-note and finance this by entering into a repurchase agreement (repo). What in effect happens is the repo counterparty lends the fund the cash to purchase the bond and the bond is pledged as security against the loan at short-term interest rates. However normally the repo counterparty won't lend the full amount, they may lend 95% (this is none as a repo haircut (5% in this case). So the fund is still required to put up 5% of the value of the bond as cash, hence the swap may be a better alternative.

Accounting and Valuation

Interest Payment Calculations

Take the following example:

Notional: 50,000,000

Fixed Rate Payer: Counterparty

Fixed Rate: 5%

Fixed Rate Payment Frequency: Semi-Annual

Floating Rate Payer: Hedge Fund X

Floating Rate: 3 Month Libor + 10 bps

Floating Rate Payment Frequency: Quarterly

Day Count Convention: A/365

Trade Date: March 30th, 2020

Effective Date: April 1st, 2020

Termination Date: March 31st, 2020

Libor rate at April 1st: 4.75%

Libor rate at July 1st: 5.25%

What would the payments be on both June 30th and September 30th.

On June 30th, only the Floating Rate Payer makes a payment (Fixed Rate Payer is semi-annual). Payment is $606,250 from Hedge Fund X to the counterparty.

This is calculated as follows:

Interest rate is 4.85% (Libor

Days in period is 91 (30+31+30)

50,000,000*4.85% = $2,425,000*91/365 = $606,250

On September 30th:

Fixed Rate Payment is: 50,000,000*5% = $2,500,000*183/365 = $1,275,000

Floating Payment is: 50,000,000*5.35% = $2,675,000*92/365 =  $695,500

These amount will be netted ($1,275,000 - $695,500) so the Counterparty pays Hedge Fund X $579,500.

Valuation

The fundamental premise to an interest rate swap is that the counterparty choosing to pay the fixed rate as well as floating rate, both technically assume they will gain some advantage in entering into IRS agreement. Of course, their assumptions will be based on their investment needs, market exposure, risk appetite and their estimates fluctuations in interest rates during the period of the swap contract.

A rule of thumb is that if interest rates rise then the Fixed Rate Payer is making money on the swap if rates fall it loses money. Conversely for the Floating Rate Payer if rates fall it makes money if rates rise it loses money.

Since, an interest rate swap is like a series of cash flows scheduled at known future dates, it can be valued by adding the present value of each of these cash flows. The value of the fixed leg is the present value of the fixed coupon payments agreed upon at the start of a swap contract. Likewise, the value of the floating leg is the present value of the floating coupon payments payable at agreed dates in the SWAP agreement. Since, at the start of the swap, only the actual payment rates of the fixed leg are known in the future, we need to use forward rates of interest (based on the swap yield curve) to calculate the cash flows on the floating leg for each respective payment date.

At the start of the swap, the PV (present value) of both the fixed and floating legs should be the same.

Bloomberg has a function that will calculate the value of a swap for you (SWPM). A screen will pop up in which you must enter all the relevant details, fixed-rate, payment dates, termination date etc. Once the data is entered it will calculate the value of the swap.

Termination Payments

At a point in time before the term of the swap expires both parties may agree to terminate the swap. At that point, interest payments are calculated and swapped. In addition, the mark-to-market of the swap is calculated and the party that is ‘Out of the Money’ must reimburse the other counterparty by way of a termination payment.

US GAAP Requirements

For accounting purposes, there are three elements to each swap, the unrealized mark-to-market (Valuation), interest income and interest expense depending on what party you are to the swap.

US GAAP requires that each of these elements be disclosed in separate line items of the financial statements. In the Statement of Operations the mark-to-market gain/loss will appear under ‘Unrealized Gains/Losses on  Derivatives’. Termination Payments would be included under ‘Realized Gains/Losses on Derivatives’. While interest income and expense will appear under those headings. On the Statement of Assets and Liabilities the mark-to-market will appear under either ‘Unrealized Gains on Swap Contracts’ or ‘Unrealized Losses on Swap Contracts’. Accrued interest must be broken out between ‘Accrued Interest Payable’ and ‘Accrued Interest Receivable’.

Additional notes on IRS:

Interest Rate Swaps

The Interest Rate Swaps that we have discussed in this course are what is known as “Vanilla” interest rate swaps. However Interest Rate Swaps can be fixed-for-fixed, fixed-for-floating or floating-for-floating. A floating-for-floating is known as a “Basis Swap”. The legs of the swap agreement can be in the same or different currencies. However, a single-currency fixed-for-fixed would be in separate currencies as the same currency would make no sense.

ISDA

The International Swaps and Derivatives Association (normally known as ISDA) was set up in 1992 to establish a legal framework for contracts such as Interest Rate Swaps. Normally the counterparty to the swap will draft a formal agreement, laid out under ISDA regulations, which will specify the parameters and specifics of each swap. As administrators, it is essential that we receive a copy of this agreement for each swap.

The ISDA agreement will normally allow for and lay out the terms by which the hedge fund must post collateral against each swap. This would normally be for the unrealized portion of each swap. In practice, there will be a “Master netting Agreement” in place which will allow all swaps with a single counterparty to be aggregated for collateral purposes so that only one amount is posted at any given time.

#IRS #SWAP #OTCderivative  #Valuation #Investment #Hedging #FixedIncome

BY: Admin Tax4wealth

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