1. Learning Objectives
Identify the types and key features of an interest rate swap (IRS)
Understand why investors trade interest rate swaps
List the key features of a trade confirm for a IRS transaction
Understand the treatment in Accounting Platform for instrument set up and recording transactions
State the process for the accounting and valuation of an interest rate swap
In a practical exercise, complete an instrument loader to create an IRS, record an IRS transaction, reconcile and value the position at month end
2. Content
Interest rate swaps (IRS) are typically used by investment managers to manage interest rate risk because every business borrows money, at either a fixed or floating interest rate, and is therefore exposed to interest rate risk. In case of rising interest rates a fixed rate may be preferable and a floating rate may be preferred when rates in the market are falling.
An interest rate swap is an agreement which involves two counterparties to exchange, over an agreed period, two series of interest payments, each based on a different type of interest for a particular notional amount. They are an exchange of one set of cash-flows (based on interest rates) for another.
Since there are no movements of principle, or cash movements, IRS are examples balance sheet instruments. As the trasactions are based on a notional amount and are valued based on the market movement, the initial capital requirements on these instruments are minimal.
2.1. Why do investors trade interest rate swaps?
Investors trade interest rate swaps for two main reasons
2.1.1. Hedging
Investors enter into interest rate swap contracts to hedge against the interest rate exposure.
For example, Party A takes out a floating rate loan. Party A did not take out a fixed rate loan because the current market conditions and Party A’s credit rating makes the fixed rate loan cost greater than the cost of the floating rate loan. The floating rate loan exposes Party A to risk of increasing interest rates. To hedge this risk, Party A can swap the floating rate liability into a fixed rate liability by entering into an agreement with another counter party (Party B) who has a fixed rate liability.
2.1.2. Comparative advantage
Investors enter into interest rate swap contracts to acquire a lower interest rate than the investor would have been able to obtain from a financial institution. For example, company A is located in the US and company B is located in the UK. Company A will borrow money in GBP and company B will borrow in USD. These two companies can get into a swap agreement in order to take advantage of their abilty to borrow cash at a more competitive rate in its respective country, as compared to a foregin one. These two companies could receive savings by combining the privileged access they in their own markets.
2.2. Features of interest rate swaps
Some important features of interest rate swaps are
2.2.1. Interest payments
There are two series of interest payments between the two parties in the contract. Generally, one party will make fixed interest payments based on the fixed interest rate and the notional principle. The other party will make floating interest payments based on a floating interest rate and the notional principle. The floating rate usually employed is Libor and applied at the beginning of the payment period.
The frequency of the payments reflects the nature of the floating rate index. For example where the floating rate is based on the 3 month Libor rate payments will be made every 3 months. The opposing fixed interest payments are normally netted against the floating payments on the settlement date. You will see the net cash-flow on the broker statement.
The notional principle that the payments are based on is never exchanged since this would involve each party giving and receiving the same amount.
2.2.2. Over-the-counter instrument
IRS are contracts that are traded “over-the-counter” (OTC) which means they are not traded on a regular exchange. They are essentially private deals arranged by your broker.
2.3. Types of interest rate swaps
There are two main types of interest rate swaps
2.3.1. Vanilla swap
This involves swapping a series of payments based on a fixed interest rate for a series of payments based on a floating interest rate. The payer of the fixed interest series is called the Payer in the swap. The receiver of the fixed interest stream is called the Receiver in the swap.
An example:
Two paties A and B agreed to exchange two streams of semi-annual cash flow, in next five years. Payment from A is a fixed rate of 6% while payment from B will be based on 6 months LIBOR which is a floating rate. The notional agreed is 10M USD.
Diagram:
6% p.a. fixed
6 month Libor
2.3.2. Basis swap
This swap involves swapping a series of payments based on a floating interest rate for a series payments based on another floating interest rate. Each party to the swap is described in terms of both the interest series it pays and the interest series that it receives.
An example:
Party A and Party B agree to swap/exchange over a period of five years, two streams of semi-annual payments. The payments made by A are calculated using periodic fixings of 6-month Libor (floating) while the payments streams from B to be calculated using periodic fixed rate of 91 day T-Bill yield which is a floating side. Notional principal amount for this contract is USD 10 million.
Diagram:
6 month Libor
91 day T-Bill
2.4. Key features of a IRS trade confirm
Some important features of interest rate swaps are
Trade date
Effective date
- Settlement date of contract.
– Date from which interest for is accrued
Maturity / Termination date
– Date the contract terminated
Fixed rate payer & fixed rate
– Payer of fixed interest amounts
– Fixed interest rate
Floating rate payer & floating rate
– Payer of floating interest amounts
– Floating rate index
Notional principle
– The interest payments are based on the notional amount.
Payment terms
– Frequency for the settlement of the net interest payment
Day count
2.5. Instrument set up
There is not an instrument type for an interest rate swap in the security master database in Ephesus. An interest rate swap is set up as two bonds in the security master database. One bond known as the “PAY” leg and the other bond is known as the “RCV” leg. Each leg is set up with a zero interest rate because typically the valuation team prices these instruments with dirty (interest inclusive) prices. The bonds for IRS are created by completing a excel instrument loader template which is uploaded into customised applications.
2.5.1. Instrument loader template
The instrument loader template is an excel spreadsheet and is available in each office from the training manager or operations manager. All fields for the template must be completed and the source for the fields is the trade confirm. Points to note
• Sectype , capitalfactor, strike ,interest type, interest percent and sectorcode fields are defaults
• Tradarid id is usually the trade reference number on confirm or can be investment manager trade ID
Example Template:
In this example, the following fields can be cross referenced to the trade confirmation in Appendix 1.
• Currency, short name, maturity date, tradarid, start date, date dated, payment frequency, coupon date and date count
The securities can be found in ay standard security master database by searching with the Trade and Security IDs.
Pay leg:
Rcv Leg:
2.6. Accounting
IRS typically does not involve a cash up-front payment from one party to another. The principle notional amount represents the quantity. The interest accruals on the fixed and floating swap legs are not accrued separately in security income ledger because open positions are valued with a market value that is inclusive of the net interest accrual (dirty pricing). At the end/close of every settlement period, the opposing netted payments are recorded in the general ledger.
2.7. Recording transactions
The transactions for an IRS can be entered manually or using loader template. The following transactions types will be used to record IRS transactions in the security ledger.
Fixed interest payer / Fixed interest receiver Open position
If Fund is fixed interest payer Fix leg = int payable
Floating Leg =int rec’ble
If Fund is fixed interest receiver Fix leg =int payable
Floating Leg = int rec’ble
The cost is the notional principle amount. The net cash amount for both transactions must be ZERO! The trade date and settlement date must also be the same so the realized currency exchange offsets to ZERO!
The following transactions have been recorded for the trade confirm in Appendix 1. The fund is the fixed interest payer.
SHS for PAY Leg:
PUR for RCV Leg:
The fund must pay the broker the netted interest payment of JPY 43,485,091 on March 20, 2007
Payment notice:
The following transaction is booked in System.
2.8. Valuation
The valuation of open interest rate contracts requires current yields and a tool to calculate the market value and accrued interest. The market value of the IRS is the net present value of future cash flows from the valuation date to the termination date of the contract.
2.8.1. Independent sources for current spread
The current yield can be sourced from Bloomberg, Reuters or brokers.
2.8.2. Calculate the market value
Bloomberg has a functionality to calculate the market value on an IRS contract. The functionality is SWPM Go.
In the example below, the details from the trade confirm are entered into SWPM screen on Bloomberg. The Bloomberg code of “JY0006M” is found 6 Month JPY Libor floating rate and entered into the index field. The market value including accrued interest is – 80,348,530
SWPM screen:
2.8.3. Price in Ephesus
The pricing of interest rate contracts in Ephesus involves calculating a notional price based on the market value obtained from Aexeo or Bloomberg. In addition, there is a long and short position for each IRS contract to be priced. The long position is generally priced with the notional price and the short position is priced at cost to have zero unrealized.
In the below example, the notional price of 99.19651470 is derived:
((10,000,000,000 – 80,348,530) / 10,000,000,000) *100
The long position is priced with 99.19651470 and the short position is priced with 100. The net unrealized loss for the IRS position is -80,348,530 and matches to Bloomberg.
2.9. Appendix 1
SWAP – GENERIC
Global Deal Id: 140xxxx
Ticketed by Application
APPLICABLE FORMS
• Deal Form
• Swap Leg: Prty A Pays Fixed 1.8613% ACT/365 FIXED S
• Operations Data
• Swap Leg: Prty B Pays 6M JPY-LIBOR ACT/360 S +0.bp
• Operations Data
________________________________________
DEAL INFORMATION
Deal Information
Orig. Office: New York
Risk Location: NY
Trade Date: Nov 15, 2006 Trade Time: 12:00 AM
Trader: XXX
Reviewer:
Party A
ID: XXX
Name: X
Party B
ID: XXXXX
Name: Lehman Brothers InternationalEurope
Branch: Head Office
Identification Numbers
Global Deal ID: X
Risk Mngmt IDs: X1
Optional Ref IDs: Y
Payments
[x] Net Payments
Describe Transaction Type
[NO] Issuer Swap
[NO] Deal Has Attachment
SWAP LEG
Dates
Effective Date: Nov 20, 2006 Maturity Date: Sep 20, 2016 [YES] Adjustment
Obligation
[x] PARTY A [x] PAYS FIXED
Notional Information
JPY 10,000,000,000
Fixed Rate Details
Percentage: 1.8613
Payment Terms
Frequency: Semi-annually
Roll Day: 20
First Pmt Date: Mar 20, 2007
Convention: Modified Following
Calendar(s): London
Tokyo
Delay/Early: 0
[x] Business Days [x] Pay in Arrears
Rate Information
Day Count: ACT/365 FIXED [YES] Period End Dates Adjust
SWAP LEG
Dates
Effective Date: Nov 20, 2006 Maturity Date: Sep 20, 2016 [YES] Adjustment
Obligation
[x] PARTY B [x] PAYS FLOATING
Notional Information
JPY 10,000,000,000
Payment Terms
Frequency: Semi-annually
Roll Day: 20
First Pmt Date: Mar 20, 2007
Convention: Modified Following
Calendar(s): London
Tokyo
Delay/Early: 0
[x] Business Days [x] Pay in Arrears
Rate Information
Floating Rate: 6 Month JPY-LIBOR 3750_Tel
Day Count: ACT/360 [YES] Period End Dates Adjust
Spread (bps): 0
Initial Rate Exc. Spread:
Reset Terms
Frequency: Semi-annually
Roll Day: 20
Calendar(s): London
Days Gap: -2
[x] Business Days [x] Reset In Advance
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