A Single Currency Interest Rate Swap (IRS) is an exchange of cash flows between two counter parties at predetermined specifications. It is an obligation between them for exchange of interest payments or receipts on investments, in the same currency on an agreed amount of notional principal at regular intervals, over an agreed period of time.
Swaps can broadly be classified into two types:
Fixed to Floating
Floating to Floating
Fixed to Floating Swap
In this type of a swap the customer receives cash flows at a fixed rate of interest and simultaneously pays cash flows at a floating rate of interest or vice versa. The cash flows are calculated on a Notional Principal amount. The floating rate of interest is usually determined by reference to a transparent benchmark.
Floating to Floating Swap
In this kind of a swap, both the counter-parties exchange interest amounts based on two different floating reference rates, through the life of the swap.
Dealing and Quotations: Trade date is the date the counterparties agree on the swap conditions. Effective date is the date that the swap becomes effective, i.e. when the interest obligations start to accrue.
Maturity date is the date the swap stops accruing interest and terminates.
Market quotations for swaps are usually quoted against standard benchmark / index rates and non-amortising national principal, free from the margin actually payable in the cash market by the relevant counterparties. The rate is thus quoted flat and any amortising structure that envisages a customised rate is adjusted accordingly.
A quote of 9.75% - 10.25% against 3 month MIBOR means that the market maker:
Pays (bid) 9.75% fixed and receives INR 3 month MIBOR
Receives (ask/offer) 10.5% fixed and pays INR 3 month MIBOR
The floating rate benchmark used may be any transparent rate available in the market. Some examples* of the floating rate benchmarks are as follows:
Overnight money rate or MIBOR
Treasury Bills yield to maturity
Term money rate
Government Securities yield to maturity
* Not all are currently available in India
Who can enter into IRS?
In the case of Rupee IRS banks, primary dealers and financial institutions are allowed to enter into swaps for the purposes of hedging their exposure as well as for market making. Other corporate customers are allowed to enter into Rupee IRS ONLY for the purposes of hedging the interest rate risk on an underlying asset/liability.
In the case of non-Rupee IRS all participants are allowed to enter into these transactions only for the purposes of hedging an underlying exposure.
