Swap Rates

Swap is a debit or credit paid or earned as a reflection of the varying interest rates applicable to currency pairs. When trading the USD for example, swap rates will be determined based on the interest rates of the countries being represented by this pair. Depending on whether you are long or short and which country has higher interest rates, you may be charged or credited interest. Essentially, when a trader holds a position over night they are subject to the interest rates applicable to the currency pair they are trading. 'Swap' is also commonly referred to as 'rollover rates'.

In the field of derivatives, a popular form of swap is the interest rate swap, in which one party exchanges a stream of interest for another party's stream. These were originally created to allow multi-national companies to evade exchange controls. Interest rate swaps are normally 'fixed against floating', but can also be 'floating against floating' rate. A single-currency 'fixed against fixed' rate swap would be theoretically possible, but since the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams. Because one party would be definitely at a disadvantage in such an exchange, that party would decide not to enter into the deal. Hence, there are no single-currency 'fixed versus fixed' swaps in existence. If there is an exchange of interest rate obligation, then it is termed a liability swap. If there is an exchange of interest income, then it is an asset swap.

Interest rate swaps are often used by companies to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a company is able to alter their interest rate exposures and bring them in line with management's appetite for interest rate risk.

Click here for a more in-depth definition of interest rate swap

Base Rate

The rate at which prime banks can borrow from the Bank of England. They use this as a base rate for general loans. The Bank of England Base Rate is set by the Monetary Policy Committee, which meets on the Wednesday and Thursday following the first Monday of each month (except in an emergency). Decisions of the Committee are announced at 12 noon immediately following the Thursday meeting. 

Basis Rate Swap

A type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates.

For example, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury Bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the Treasury Bill rate for the LIBOR rate, they eliminate this interest-rate risk.

The Federal Funds Rate

Libor (London Inter Bank Offer Rate)

The rate at which banks are prepared to lend to each other for different periods of time. Loans for property are normally linked to this rate and expressed as a margin over LIBOR, e.g. 50 basis points over LIBOR (1 basis point equates to 1 hundredth of a percentage point).

Euribor® (Euro Interbank Offered Rate)

European banks considered that the introduction, in 1999, of the single currency made it necessary to establish a new interbank reference rate within the Economic and Monetary Union: Euribor®.

Euribor® (Euro Interbank Offered Rate) is the benchmark rate of the large euro money market that has emerged since 1999. It is sponsored by the European Banking Federation (FBE), which represents the interests of 4 500 banks in 24 Member States of the European Union and in Iceland, Norway and Switzerland and by the Financial Markets Association (ACI).
Euribor® is the rate at which euro interbank term deposits are offered by one prime bank to another prime bank and is published at 11.00 a.m. CET for spot value (T+2).

Euribor® was first published on 30 December 1998 for value 4 January 1999.

The choice of banks quoting for Euribor® is based on market criteria. These banks are of first class credit standing. They have been selected to ensure that the diversity of the euro money market is adequately reflected, thereby making Euribor® an efficient and representative benchmark.

A strict Code of Conduct sets out rules covering, amongst other things:

Reuters (formerly Moneyline Telerate) has been chosen as the screen service provider responsible for computing and publishing Euribor®.

Since its launch, Euribor® has become a reality on the derivatives markets and is the underlying rate of many derivatives transactions, both OTC and exchange-traded.

Gilt Rate

Gilt are tradable bonds issued by the government with a fixed (or index linked) coupon or interest rate, usually with a fixed redemption date. For example, Treasury 9% 2009 mean a stock issued by the Treasury with a 9% coupon that will be repaid in 2009. The yield on a gilt will not always be the coupon as the price will change in the market. Gilt yields are quoted on either an initial yield or yield redemption basis. The former is simply the current income yield, while the latter takes into account the repayment of capital (the principal) at the gilt expiry date.

Cap

This is essentially an insurance policy purchased by the borrower which literally puts a 'cap' or upper limit on the floating rate of interest on the loan and therefore is a hedging instrument.

Cap Rate

This is the price a borrower pays (in basis points) as a percentage of the capped loan amount in order to place an upper limit on a floating rate of interest. This cost is incurred up-front and the cost of the cap will vary according to the degree of protection required. The cost of a cap can be reduced by selling a 'floor'. A floor will set a lower limit below which the borrower cannot benefit from any further interest rate reductions. The combination of a cap and a floor is called a 'collar'. It is possible to structure a 'no-cost collar' where the cost of the cap is fully offset by the price received for selling a floor.