Certain Terminologies You Should Know When Using Interest Rate Swaps

Interest rate swaps is a mutual agreement between two parties where one party agrees to exchange their payments for another with a willing party. While there are many types of swaps that can be performed, the most basic is known as the plain vanilla swap, where one fixed rate is exchanged for a floating one.

Businesses use this investment tools all of the time to reduce risk, manage debt, improve profits, and for portfolio management. If you are reading this article right now, you must at some point thought of using this tool at some point. But jumping into the use of these tools without a clear understanding of the basic might be costly, hence we are providing you with the right guide.

This article is meant to provide you with the basic understanding of the common terms you will need to know when using interest rate swaps.

The Common Rate Swap Terminologies

“Notional”- This is the term that defines the base of all the payments for your fixed and floating interest rates. For instance, if you were swapping a loan worth ‘x’ amount of money, the swap’s notional would be equal to ‘x’ as well. This defines how much should be paid for a particular coupon and doesn’t really get exchanged.

Fixed Rate- The amount and number of payments that the fixed party makes is called the swap’s fixed leg. The calculation of these rates are done using fixed rates.

Coupon Frequency- Coupon frequency refers to the number of times interest rates are exchanged between two parties. These coupon frequency can take place as often as agreed by the two parties. If the two parties are working with plain vanilla swap, the payment streams may vary in frequency, but the coupons maintain the same frequency.

The Floating Index- This is used to decide the index which will be used on floating coupons. For instance, most investors and traders use LIBOR, the London Interbank Offered Rate.

The Business Day Convention- This is used to determine how the dates for coupons are adjusted for holidays and non-working days. In most cases, conventions are organized the following business day or a modified day following the holiday.

Effective Date- When two parties agree to take part in an interest rate swap opportunity and begin accruing their first coupon, this is known as the start, or effective, date of the swap.

The Maturity Date- Before the swap’s effective date, the two parties come to an agreement about many factors of the swap. One of the factors is the maturity date of the swap. This date signifies the end date of the coupon and relinquishes both parties from any obligations they may have had during the rate swap.

The Volatility- Interest rate swap, like many parts of financial management, is a risk and is often governed by a volatile market. Understand volatility, or changes that occur in the market and affect interest rates and option pricing is essential to a successful swap.

If you want to start taking part in interest rate swaps, these are some of the terminologies you need to understand so that you can be truly successful.