Unsecured interest rate swaps – those executed bilaterally in the absence of CSA – expose counterparties to financing and credit risk. Funding involves risks because the value of the swap can become so negative that it is prohibitive and cannot be financed. credit risk, because the counterparty concerned, for which the value of the swap is positive, will be concerned that the opposing counterparty is not complying with its obligations. On the other hand, guaranteed rate swaps expose users to security risks: depending on the conditions of the CSA, the type of reserved guarantee that is allowed may become more or less expensive due to other external market movements. The actual description of an interest rate swap (IRS) is a derivative contract agreed between two counterparties, which indicates the nature of a payment exchange compared to an interest rate index. The most widely used IRS is a fixed swap for free float, in which one party makes payments to the other party on the basis of a fixed interest rate initially agreed to obtain additional payments based on a variable interest rate index. Each of these payment series is called “leg,” so a typical IRS has both a fixed leg and a floating leg. The floating index is usually an interbank offer rate (IBOR) with a specific maturity in the corresponding currency of the IRS, for example. B LIBOR in GBP, EURIBOR in EUR or STIBOR in SEK. Variable leg calculation is a similar process that replaces the fixed rate with expected index rates: given these concerns, banks typically calculate a credit valuation adjustment as well as other X valuation adjustments that incorporate these risks into the value of the instruments. Interest rate swaps are also popular because of the arbitrage opportunities they offer. Different credit levels mean that there is often a positive quality differential that allows both parties to benefit from an interest rate swap. Interest rate swaps have become an indispensable instrument for many types of investors, as well as for corporate treasurers, risk managers and banks, as they have so many possibilities of use.
These include a company called TSI, for example, 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. Hedging interest rate swaps can be complex and relies on well-designed digital risk model processes to deliver reliable benchmark trades that reduce all market risks. See, however, the discussion above on protection in a multi-curve environment. The other risks mentioned above must be covered by other systematic procedures. .