Amortizing Swap

What Is an Amortizing Swap?

An amortizing swap is an interest rate swap where the notional principal amount is reduced at the underlying fixed and floating rates.

Understanding Amortizing Swaps

An amortizing swap, also called an amortizing interest rate swap, is a derivative instrument in which one party pays a fixed rate of interest while the other party pays a floating rate of interest on a notional principal amount that decreases over time. The notional principal is tied to an underlying financial instrument with a declining (amortizing) principal balance, such as a mortgage. An amortizing swap is an exchange of cash flows only, not principal amounts.

As with plain vanilla swaps, an amortizing swap is an agreement between two counterparties. The counterparties agree to exchange one stream of future interest payments for another, based on a specified principal amount. Amortizing swaps are used to reduce or increase exposure to fluctuations in interest rates. They can also help obtain a marginally lower interest rate than would have been possible without the swap. The main difference with amortizing swaps is the principal amount of the swap declines over time, typically on a fixed schedule. For example, an amortizing swap could be tied to a real estate mortgage that is being paid down over time.

Interest rate swaps are a popular type of derivative agreement between two parties to exchange future interest payments for one another. These swaps trade over-the-counter (OTC) and are contracts that can be customized to the respective parties' desired specifications. There are many ways to customize the swaps.

The notional principal in an amortizing swap may decrease at the same rate as the underlying financial instrument. The interest rates may also be based on a benchmark, such as a mortgage interest rate or the London Inter-bank Offered Rate (LIBOR).

An amortizing swap typically consists of fixed and floating legs and its value is derived from the present values of these legs. It is important (especially to the fixed-rate receiver) that the amortization schedules of the swap and the underlying are set at identical levels.

The following is the present value (PV) of an amortizing swap if receiving the floating rate and paying the fixed rate.

PV Amortizing Swap = PV Floating − PV Fixed \text{PV}_{\text{Amortizing Swap}} = \text{PV}_{\text{Floating}} - \text{PV}_{\text{Fixed}} PVAmortizing Swap=PVFloating−PVFixed

The following is the present value of an amortizing swap if receiving the fixed-rate and paying the floating rate.

PV Amortizing Swap = PV Fixed − PV Floating \text{PV}_{\text{Amortizing Swap}} = \text{PV}_{\text{Fixed}} - \text{PV}_{\text{Floating}} PVAmortizing Swap=PVFixed−PVFloating

OTC transactions, like swaps, have counterparty risk. The transactions are not backed by an exchange, and therefore there is a risk that one party may not be able to deliver on their side of the contract.

The opposite of an amortizing swap is an accreting principal swap. With an accreting swap, the notional principal amount will increase over the life of the swap. One of the key aspects of both an amortizing swap and an accreting swap is that the notional principal amount is affected over the life of the swap agreement. This contrasts with other types of swaps, where the notional principal amount remains unaffected over the life of the swap.

Example of an Amortizing Swap

In real estate, an investment property owner might finance a large multi-unit property with a mortgage tied to a fluctuating LIBOR or short-term Treasury interest rate. However, they lease the property units and receive a fixed payment. To protect against rising interest rates on the property's mortgage, the owner might enter into a swap agreement where they will swap fixed for floating rates. This assures that if rates change, they will be able to cover the floating mortgage payments.

The downside of the swap is that if interest rates fall, the owner of the property would have been better off not entering the swap. As interest rates fall, they are still paying the fixed amount for the swap. If they hadn't entered the swap, they would simply be benefiting from lower interest rates on the mortgage.

Swaps aren't typically entered for speculative purposes though. Instead, they are used to hedge or limit the downside, which is important to most businesses and organizations.

The hedge may not match perfectly due to the number of day counts, maturities, call features, and other differences, but it would mitigate most of the risk of rising interest rates for the property owner.