Liability Swap

What is a liability swap?

A liability swap is the exchange of interest rates between two entities, generally a fluctuating stream of interest payments is traded in return for a consistent stream of cash flows.

For instance, corporation X may trade a 3-month London Interbank Offered Rate (LIBOR), which is variable, in return for a fixed rate of 4% on hypothetical principle of $1,000,000 with corporation Y. Importantly, this $1,000,000 is a notional amount used only to calculate the size of the cash flows to be exchanged, $1,000,000 is not actually exchanged. After the exchange, corporation X will no longer be responsible for paying the LIBOR rate interest on $1,000,000 but will instead pay corporation Y the fixed rate of 4% interest. In return, corporation Y will pay corporation X the variable LIBOR interest rate on $1,000,000. In this example, corporations X and Y would be called “counterparties.”

When the swap is initiated, it is priced to have a net present value of zero, but actual value over the course of the swap is dependent on the variable interest rate fluctuations.

Why are liability swaps done?

Liability swaps are undertaken for numerous reasons. For instance, they allow businesses to hedge against interest rate exposure. They are also used by speculators to make bets on interest rate changes.

What are the different types of liability swaps?

Liability swaps most commonly vary in two ways: whether fixed or floating interest rate cash flows are being exchanged and the currency of each of the cash flows. Thus, there are “fixed-for floating rate swaps” in the same currency as well as different currencies, “floating-for-floating rate swaps” in the same currency as well as different currencies,” as well as “fixed-for-fixed rate swaps” in different currencies. Note that fixed-for-fixed rate swaps in the same currency are not generally done because the cash flow stream for the life of the swap can be calculated at the outset.

How big is the liability swap market?

The notional value of outstanding interest rate swaps is estimated to be in excess of $350 trillion. Interest rate swaps are the largest single component of the global Over-the-Counter (OTC) derivative market.