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Fundamentals of IRS
Fundamentals of IRS
Fundamentals of IRS
ISSUE BRIEF
ALIFORNIA
D EBT AND
INVESTMENT
A DVISORY
Introduction
The actual market value (i.e. the value of
Interest rate swaps have emerged from the
transactions based on current interest rates)
domain of giant global organizations to
however is also a significant amount, at
become an integral part of the larger world of
approximately $4 trillion dollars.
governmental and corporate finance.
This Issue Brief attempts to provide basic
The first interest rate swap was a 1982
information regarding the use of interest rate
agreement in which the Student Loan
swaps in municipal finance. It reviews data a
Marketing Association (Sallie Mae) swapped
financial manager would need to know when
the interest payments on an issue of
considering the use of interest rate swaps in
intermediate term, fixed rate debt for floating
the organization’s borrowing program. They
rate interest payments indexed to the three
include:
month U.S. Treasury bill. The interest rate
swap market has grown rapidly since then. • Characteristics of an interest rate swap
Figure 1 – Global Interest Rate Swap Market • Pricing, costs, and the mechanics of
terminating an interest rate swap
Notional $ Market Value • Participants in an interest rate swap
120 4.5
4 • Typical uses of an interest rate swap
Notional Value (in $ trillions)
100
3.5 • Documentation, risks, and disclosure
80 3
2.5 associated with an interest rate swap
60
2 • Effects on credit ratings
40 1.5
1 • Creating a swap management policy
20
0.5
0 0
A fixed to floating rate swap allows an Issuer Example 1: Floating to Fixed Rate Swap
with fixed rate debt to take advantage of The Issuer issues $10,000,000 of variable rate
variable interest rates. The Issuer’s net debt bonds. The variable rate bonds initially bear
service costs will be lower if the floating interest at 1.5 percent, but the rate can change
swap rate paid by Issuer to the Counterparty weekly. The Issuer then enters into a swap
remains below the fixed swap rate received contract with a financial institution (the
by the Issuer. “Counterparty”). Under the swap contract,
the Issuer agrees to pay the Counterparty a
Either of the two structures noted above can fixed interest rate of 4.0 percent, and the
be used in conjunction with existing debt or Counterparty agrees to pay the Issuer a
can be combined with newly issued debt. In variable rate based on an index, which
addition, there is an increasing use of the approximates the variable rate on the Issuer's