There is no consensus on the scope of naming convention for different types of IRS. Even a wide description of IRS contracts only includes currency forex cross rate free magazine whose legs are denominated in the same currency. It is generally accepted that swaps of similar nature whose legs are denominated in different currencies are called cross currency basis swaps.
In traditional interest rate derivative terminology an IRS is a fixed leg versus floating leg derivative contract referencing an IBOR as the floating leg. If the floating leg is redefined to be an overnight index, such as EONIA, SONIA, FFOIS, etc. Some financial literature may classify OISs as a subset of IRSs and other literature may recognise a distinct separation. Fixed leg versus fixed leg swaps are rare, and generally constitute a form of specialised loan agreement.
Float leg versus float leg swaps are much more common. The legs on SBSs will necessarily be different interest indexes, such as 1M, LIBOR, 3M LIBOR, 6M LIBOR, SONIA, etc. The pricing of these swaps requires a spread often quoted in basis points to be added to one of the floating legs in order to satisfy value equivalence. Interest rate swaps are used to hedge against or speculate on changes in interest rates. Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them.
Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Interest rate swaps are also popular for the arbitrage opportunities they provide. Varying levels of creditworthiness means that there is often a positive quality spread differential that allows both parties to benefit from an interest rate swap. The interest rate swap market in USD is closely linked to the Eurodollar futures market which trades among others at the Chicago Mercantile Exchange. A vanilla IRS is the term used for standardised IRSs. Typically these will have none of the above customisations, and instead exhibit constant notional throughout, implied payment and accrual dates and benchmark calculation conventions by currency.
A vanilla IRS is also characterised by one leg being ‘fixed’ and the second leg ‘floating’ referencing an -IBOR index. IBOR index rates of the appropriate currency. Historically IRSs were valued using discount factors derived from the same curve used to forecast the -IBOR rates. Some early literature described some incoherence introduced by that approach and multiple banks were using different techniques to reduce them. Post crisis, to accommodate credit risk, the now-standard pricing framework is the multi-curves framework where forecast -IBOR rates and discount factors exhibit disparity.
Note that the economic pricing principle is unchanged: leg values are still identical at initiation. Regarding the curve build, under the old framework a single self discounted curve was “bootstrapped”, exactly returning the prices of selected instruments. Under the new framework, the various curves are best fitted — as a “set” — to observed market data prices, one for discounting, one for each forecast curve as below. The complexities of modern curvesets mean that there may not be discount factors available for a specific -IBOR index curve. These curves are knows as ‘forecast only’ curves and only contain the information of a forecast -IBOR index rate for any future date.
IBOR index in a given currency. During the life of the swap the same valuation technique is used, but since, over time, both the discounting factors and the forward rates change, the PV of the swap will deviate from its initial value. Therefore, the swap will be an asset to one party and a liability to the other. Interest rate swaps expose users to many different types of financial risk. Predominantly they expose the user to market risks. The value of an interest rate swap will change as market interest rates rise and fall.
In market terminology this is often referred to as delta risk. Funding risks because the value of the swap might deviate to become so negative that it is unaffordable and cannot be funded. Credit risks because the respective counterparty, for whom the value of the swap is positive, will be concerned about the opposing counterparty defaulting on its obligations. Collateralised interest rate swaps expose the users to collateral risks. Depending upon the terms of the CSA, the type of posted collateral that is permitted might become more or less expensive due to other extraneous market movements. Credit and funding risks still exist for collateralised trades but to a much lesser extent.
Due to regulations set out in the Basel III Regulatory Frameworks trading interest rate derivatives commands a capital usage. Dependent upon their specific nature interest rate swaps might command more capital usage and this can deviate with market movements. Thus capital risks are another concern for users. The mis-selling of swaps, over-exposure of municipalities to derivative contracts, and IBOR manipulation are examples of high-profile cases where trading interest rate swaps has led to a loss of reputation and fines by regulators. Hedging interest rate swaps can be complicated and relies on numerical processes of well designed risk models to suggest reliable benchmark trades that mitigate all market risks. The other, aforementioned risks must be hedged using other systematic processes. The cross disciplines required include quantitative analysis and mathematical expertise, disciplined and organized approach towards profits and losses, and coherent psychological and subjective assessment of financial market information and price-taker analysis.