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Common Terminology to Know When Using Interest Rate Swaps

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Interest rate swaps occur when one party agrees to exchange their payment 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 here reading this article right now, there's a good chance you have been thinking of using this type of derivative for your business as well. However, jumping into this type of financial risk management can be confusing and costly if you don't know what you are doing, so let us help you with just a few basics.

In the following article, we are going to discuss some of the most common terms you will come across when performing interest rate swaps.

Common Rate Swap Terminology

    Notional - The notional, or notional principles is what all payments for your fixed and floating rates are based on. 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 element is generally only used for determining how much should be paid for each coupon, and is usually never exchanged.

    Fixed Rate - The amount and number of payments paid by the fixed party is known as the swap's fixed leg. These payments are calculated using a fixed rate.

    Coupon Frequency - Rates of interest can be exchanged more than one time between two parties, and this is known as coupon frequency. This coupon frequency generally occurs monthly, quarterly, or annually, but can occur much more often, depending on the agreement between the two parties. If the interest rate swap is a plain vanilla swap, the payment streams may vary in frequency, but the coupons for both parties should maintain the same frequency.

    Floating Index - The floating index determines which index will be used on floating coupons. In general, LIBOR, or the London InterBank Offered Rate, is used by most investors and traders.

    Business Day Convention - This term determines how the dates established for coupons are adjusted for holidays and non-business days. Most of the time the following business day or a modified following day are used as conventions.

    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.

    Maturity Date - Before the swap's effective date, the two parties come to an agreement about many factors of the swap. One of those factors must always be the maturity date of the rate of interest 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.

    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 rates of interest and option pricing is essential to a successful swap.

If you are thinking of taking part in interest rate swaps because it will benefit your business, make sure you know and understand the most common terminology so you can be successful.

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