FINA 2710 Lecture Notes - Lecture 3: Interest Rate Swap, Currency Swap, Cash Flow
Document Summary
An interest rate swap is an agreement in which two parties agree to periodically exchange fixed and floating rates of interest over a period of time. The long position (i. e. swap buyer) receives floating and pays fixed. The short position (i. e. swap seller) receives fixed and pays floating. Neither the long nor short position to an interest rate swap pays or receives a premium at initiation. Hence, the counterparties agree to a fixed rate that is perceived as fair to both. Fair fixed rate is one that is equal to the expected levels of the floating rate. This fixed rate does not change during the life of the swap. After initiation, the floating rate will either increase or decrease over time. The fluctuation benefits one party and harms the other. The most commonly used floating rate is libor at which banks borrow from each other. The maturity of the swap is called tenor.
