There are three different types of interest rate swaps: fixed-to-floating, floating-to-fixed and float-to-float. So far, we have understood that FRAs help us move interest rates. Sum of all futures contracts with continuous (or discrete) interest rates, each contract being considered to be as follows: in the case of a simple vanilla swap, the variable interest rate of the next cash flow is chosen as the current interest rate. The data on which the variable interest rate is set is called fixed data. A set date is usually two days before the payment date, so the overnight payment is an indication: The current value is calculated as exp^ (rate for the current period x current period) Interest rate swaps are the replacement of one set of cash flows for another. Because they act on the counter (OTC), contracts between two or more parties are concluded according to their specifications and can be adapted in many different ways. Swaps are often used when a company can easily borrow money at one type of interest rate, but prefers another type. An entity that does not have access to a fixed-rate loan can borrow at a variable rate and enter into a swap to obtain a fixed rate. The variable rate term, resilience and payment dates of the loan are reflected and cleared on the swap. The fixed-rate portion of the swap becomes the entity`s interest rate.
The image shows that on each fixing date, the variable interest rate is determined for the next period. A swap can also include replacing one type of variable rate for another, called a base swap. FWD can lead to currency exchange, which would involve a transfer or billing of money to an account. There are periods of conclusion of a clearing contract that would be at the exchange rate in force. However, the netting of the futures contract has the effect of settling the net difference between the two exchange rates of the contracts. The effect of a FRA is to settle the cash difference between the interest rate differentials between the two contracts. For example, imagine a company called TSI, which can issue a loan at a fixed rate that is very attractive to its investors. The company`s management believes that with a variable interest rate, it can generate better cash flow.
In this case, TSI may enter into a swap with a counterparty bank in which the entity receives a fixed interest rate and pays a variable interest rate. The swap is structured to match the duration and cash flow of the fixed-rate loan, and the two fixed-rate cash flows are offset. TSI and the bank choose the prime variable rate index, which is usually LIBOR for a period of one, three or six months. TSI then receives the LIBOR more or less a spread reflecting both the interest rate conditions in the market and its credit quality. An advance interest rate agreement (FRA) is a contract between two parties for the exchange of interest payments on a certain nominal nominal amount for a future period of predetermined duration (i.e. one month in advance for three months). Indeed, a FRA is a one-year short-term interest rate swap. Only interest rate flows are exchanged and no capital is exchanged. In a generic FRA, one part pays firm and the other pays variable.
This exchange makes it possible to convert variable-rate financing into fixed-rate or fixed-income transactions into variable-rate commitments. In this section, I will explain how we can reward a simple vanilla-IRS exchange. There are two common strategies for valuing a swap: [US$ 3×9 – 3.25/3.50% p.a] – means that interest rates on deposits are 3.25% from 3 months for 6 months and the credit interest rate from 3 months is 3.50% (see also monetary mail margin). Entering an “FRA payer” means paying the fixed interest rate (3.50% per year) and getting a 6-month variable rate, while entering a “receiver-FRA” means paying the same variable rate and getting a fixed rate (3.25% per year).