Interest rate swaps are a popular derivative used by financial and non-financial companies.
In a plain vanilla interest rate swap, two parties agree to exchange cash flows at specific times in the future, with one party’s cash flows based on a fixed rate and the other party’s cash flows based on a floating rate (which is usually pegged to a floating rate index like the LIBOR).
There is a fixed-payer and a floating-payer, and each party’s cash flows are in the same currency and have the same notional amount.
The fixed rate in the transaction is known as the “swap rate.” It is determined so that the value of the swap contract is zero on the swap’s inception date. For the initial value of a swap to be zero, the value of the fixed-rate bond and floating-rate bond must be equal. For this reason, there is no premium paid by either the fixed-payer or floating-payer to enter into a plain vanilla interest rate swap.
The market makers for interest rate swaps are usually commercial banks and investment banks; they will serve as either the fixed-payer or the floating-payer.
Financial news companies collect and publish the fixed rates that banks are willing to pay or receive on interest rate swaps (bid and offer rates).
The notional amounts are not exchanged at the beginning of the contract. On payment dates, only the difference in interest changes hands.
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