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What is derivative? It refers to a financial instrument derived from another asset, or index. Derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset.

What is interest rate Swap? An interest rate Swap occurs when two parties exposed to opposite types of interest rate risk. It a derivative when one party exchanges a stream of interest payments for another’s party stream of cash flows. Interest rate swap often build upon the LIBRE + % (set interest rate).

The Swap agreement sample: A company would make fixed rate payments to the corporation based on a notional amount. The Corporation will pay the company an adjustable interest rate on the same notional amount.

According to the Green Interest Rate Swap Management, swap is a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is known as a fixed-for-floating interest rate swap. On the other hand, both series of cashflows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Very popular money-market swap are the Libor and Commercial paper or Treasury Bills.

At the time the Swap being priced, the future stream of the floating rate is unknown. Never the less, while examining inflation to determine future interest rates trends, we could look at various relationships between interest rates and future period of time (i.e. yield curve).