Interest rate swaps come up when a company with floating-rate borrowing wants to fix its interest payments, and when a financial institution wants to adjust the gap between the rates on its deposits and its loans.

Exchanging a fixed rate for a floating rate

In an interest rate swap that exchanges a fixed rate for a floating rate, one party pays interest at a fixed rate and the other pays interest at a floating rate. Both amounts are calculated by applying each rate to the same notional amount agreed in the contract1. The floating rate is set for each interest period from a market benchmark rate. Yen interest rate swaps use benchmarks such as TONA (the uncollateralized overnight call rate) and TIBOR2.

Consider a hypothetical example in which Bank A and Company B enter into an interest rate swap with a notional amount of 10 billion yen, a term of 3 years, and one interest payment a year. Company B pays a fixed rate of 1% a year and receives the floating rate. Bank A does the opposite: it receives the fixed rate and pays the floating rate.

The notional amount is a principal used only to work out the interest, and it is not exchanged at the start or at the end of the trade3. So even in a swap with a notional of 10 billion yen, the only money that changes hands is interest.

Cash flows for the fixed-rate payer

For Company B, each annual payment is 100 million yen (10 billion yen × 1%), fixed when the trade is agreed. What it receives, however, depends on the floating rate for each year, so the amount is not known when the trade is agreed. Assume the floating rate turns out to be 0.5% in year 1, 1% in year 2, and 1.5% in year 3. Company B's cash flows (money received and paid) are then as follows.

↑ Receive　↓ PayFrom Company B's side (fixed-rate payer)Year 1Year 2Year 3+50 million yenFloating−100 million yenFixed+100 million yenFloating−100 million yenFixed+150 million yenFloating−100 million yenFixed
Figure 1Interest rate swap cash flows for Company B
Figure description

These are the payments of Company B, the pay-fixed side, assuming the floating rate is 0.5% in year 1, 1% in year 2, and 1.5% in year 3. On each payment date at the end of years 1, 2 and 3, Company B pays 100 million yen of fixed-rate interest. It receives floating-rate interest of 50 million yen in year 1, 100 million yen in year 2, and 150 million yen in year 3. Only the amount received changes from year to year; the amount paid is the same every year.

The table below shows the payments on each payment date. A positive net amount is received by Company B, and a negative one is paid by Company B. This example calculates interest as exactly one year's worth each time.

Payment date Floating rate (assumed) Received: floating interest (million yen) Paid: fixed interest (million yen) Net (million yen)
Year 1 0.5% 50 100 −50
Year 2 1% 100 100 0
Year 3 1.5% 150 100 50

The parties can agree to settle the interest due on the same date by exchanging only the difference (net settlement). A document on Japanese yen OIS (overnight index swaps) shows an example in which the difference is settled on each payment date4. With net settlement in the example above, Company B pays 50 million yen in year 1, nothing changes hands in year 2, and Company B receives 50 million yen in year 3.

When the floating interest is set depends on the benchmark. In trades using TIBOR, it is set before the interest period starts; in trades that compound TONA, it is set at the end of the period5.

Which side gains when rates move

The fixed-rate payer gains when the floating rate rises and loses when it falls. The receive-fixed side is in the opposite position. In the example, in year 1, when the floating rate is 0.5%, Company B pays 50 million yen and Bank A receives 50 million yen. In year 3, when the floating rate is 1.5%, Company B receives 50 million yen and Bank A pays 50 million yen. Neither side knows the future level of the floating rate when the trade is agreed.

How to work out what a swap is worth partway through its life (its market value), and how that value changes when market rates move, is covered in Valuing an Interest Rate Swap.

Using swaps to turn payments into fixed or floating rates

A company with a floating-rate loan pays more interest when rates rise. Suppose this company enters into a swap with Bank A in which it receives the floating rate in return for paying a fixed rate. The floating interest it receives from the swap covers the floating interest on its loan. The company is left paying only the fixed rate on the swap, the same as it would on a fixed-rate loan6.

Take the case where Company B has borrowed 10 billion yen, the same as the notional, from Bank C for 3 years at the same floating rate as the swap (with no spread added).

Bank CLenderCompany BBorrowerBank ACounterpartyFloatingFloatingFixed 1% a year
Figure 2Combining a floating-rate loan with an interest rate swap
Figure description

These are the payments among three parties: Bank C, Company B, and Bank A. Company B pays floating-rate interest to Bank C on its loan. At the same time, under its swap with Bank A, it receives floating-rate interest from Bank A and pays Bank A a fixed rate of 1% a year. The two floating amounts are equal and cancel out, so Company B's only interest cost is the fixed rate of 1% a year.

Company B's interest payments are 100 million yen every year, however the floating rate moves. In year 3, when the floating rate rose to 1.5%, it pays 100 million yen instead of the 150 million yen it would have paid without the swap, a gain of 50 million yen. In year 1, when the floating rate fell to 0.5%, it pays 100 million yen instead of 50 million yen, a loss of 50 million yen6. Even when rates fall, Company B's payments stay at 100 million yen. How companies use hedges is covered in How Corporates Use Derivatives.

A swap can also be used the other way. A company with a fixed-rate loan can add a swap in which it receives a fixed rate and pays a floating rate, so that its interest payments look like those on a floating-rate loan7.

Financial institutions sometimes hold fixed-rate bonds or loans funded by money whose rate changes, such as deposits. A swap in which they pay a fixed rate and receive a floating rate can then close the gap between the rates on their funding and their assets8.

Interest rate risk and counterparty risk

Fixing interest payments with a swap does not remove gains and losses from rate movements. In the example above, Company B paid more in the year rates fell than it would have without the swap. Since no one knows how rates will move, the risk from rate changes cannot be eliminated entirely9.

When the parties enter into a swap directly with each other over the counter (bilaterally), each must take the other's credit risk into account. A clearing house, or central counterparty (CCP), takes over the parties' obligations, becomes the counterparty to each side, and guarantees settlement. In theory, participants therefore do not bear the credit risk of individual counterparties directly10. Clearing interest rate swaps through a CCP also reduces counterparty risk11.

Clearing in practice

Japan Securities Clearing Corporation (JSCC) has cleared interest rate swaps since October 2012 as over-the-counter (OTC) derivatives, separately from exchange-traded products12. It clears yen interest rate swaps that use TONA or TIBOR as the floating rate and meet conditions set by JSCC2.

How it differs from similar trades

Interest rate swaps come in several types, depending on which rates are exchanged. Besides the common exchange of a fixed rate for a floating rate, some swaps exchange one floating rate for another13.

Trade Rates exchanged Example floating rates
Interest rate swap (fixed for floating) Fixed rate and floating rate TIBOR, compounded TONA
Overnight Index Swaps (OIS) Fixed rate and a floating rate that compounds an overnight rate Compounded TONA
Basis Swaps Floating rate and floating rate Compounded TONA and TIBOR, or TIBOR of different tenors

JSCC also clears swaps that exchange TIBOR for TONA, and swaps that exchange TIBOR of different tenors2.

Notes

  1. Japan Exchange Group, "スワップ（用語集）" (Swap, glossary, in Japanese). ↩

  2. Japan Securities Clearing Corporation, "清算対象取引（金利スワップ）" (Eligible trades for clearing: interest rate swaps, in Japanese): the table of eligible products and "1．定義集" (Definitions), "2．取引相手方の要件" (Counterparty requirements), and "7．通貨" (Currency). The conditions include being based on the definitions of the International Swaps and Derivatives Association (ISDA), being between clearing participants, and being denominated in yen. ↩ ↩2 ↩3

  3. Central Council for Financial Services Information, "4-2 金利スワップの仕組み（やさしいデリバティブ）" (How interest rate swaps work, Easy Derivatives, in Japanese), "想定元本" (Notional amount). ↩

  4. Study Group on Risk-Free Reference Rates, "日本円ＯＩＳ（Overnight Index Swap）─取引の概要と活用事例─" (Japanese yen OIS: overview and use cases, information as of March 2018, in Japanese), "基本的な取引方式" (Basic trading method), page 5, "決済方法：差金決済" (Settlement method: net settlement), and "例１" (Example 1), page 6. ↩

  5. The same document, "（１）IBOR と OIS レートの性質の違い" (Differences in the nature of IBOR and OIS rates), pages 7–8. It describes IBOR (including TIBOR) as "変動金利の受払額も金利計算期間の前に決定" (the floating amount is also set before the interest period, our translation) and OIS as "変動金利の受払額が金利計算期間の満期日に確定" (the floating amount is fixed on the last day of the interest period, our translation). ↩

  6. Central Council for Financial Services Information, "4-2 金利スワップの仕組み（やさしいデリバティブ）" (in Japanese), "スワップ取引利用例" (Example of using a swap). ↩ ↩2

  7. The same document, "変動金利と固定金利の交換する金利スワップの例" (Example of an interest rate swap exchanging floating and fixed rates). ↩

  8. Study Group on Risk-Free Reference Rates, "日本円ＯＩＳ（Overnight Index Swap）─取引の概要と活用事例─" (information as of March 2018, in Japanese), "（ALM スワップ）" (ALM swaps), page 9. The document describes this as an example using OIS. ↩

  9. Central Council for Financial Services Information, "4-2 金利スワップの仕組み（やさしいデリバティブ）" (in Japanese), the explanation following "スワップ取引利用例" (Example of using a swap). ↩

  10. Japan Securities Clearing Corporation, "JSCCとは" (About JSCC, in Japanese), "「清算機関」の機能" (Functions of a clearing house) and "（２）安全性の向上" (Improved safety) under "JSCCの役割" (Role of JSCC). The document explains the functions of a clearing house using trading in securities and commodity markets as the example. ↩

  11. Study Group on Risk-Free Reference Rates, "日本円ＯＩＳ（Overnight Index Swap）─取引の概要と活用事例─" (information as of March 2018, in Japanese), "（清算適格取引の拡充）" (Expanding eligible trades for clearing), page 12. ↩

  12. Japan Securities Clearing Corporation, "JSCCとは" (in Japanese), "沿革" (History). ↩

  13. Study Group on Risk-Free Reference Rates, "日本円ＯＩＳ（Overnight Index Swap）─取引の概要と活用事例─" (information as of March 2018, in Japanese), "（OIS の定義）" (Definition of OIS), page 3. ↩