What is an Amortizing Swap
An amortizing swap, or amortizing interest rate swap, is a derivative instrument in which one party pays a fixed rate of interest and the other party pays a floating rate of interest. Both payments are based 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. Only cash flows, not principal amounts, are exchanged.
BREAKING DOWN Amortizing Swap
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 would be tied to a real estate mortgage.
Interest rate swaps are derivatives which exchange one cash flow for another. These swaps trade over-the-counter (OTC) and are contracts between two or more parties, according to their desired specifications. There are many ways to customize the swaps. An investor will use interest rate swaps if they can borrow money easily at one type of interest rate but prefer to trade in a different currency.
The notional principal in an amortizing swap may decrease at the same rate as the underlying financial instrument. The principal may also have a base rate of a benchmark, such as a mortgage interest rate or the London Interbank Offered Rate (LIBOR).
The opposite of an amortizing swap is an accreting principal swap. With the accreting swap, its notional principal will increase over the life of the swap. In most swaps, the amount of notional principal remains the same over the life of the swap.
Benefits of an Amortizing Swap
In real estate, an investment property owner might finance a property with a mortgage tied to the LIBOR or a short-term Treasury interest rate. However, they lease the property 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. The hedge may not match perfectly, due to the number of day counts, maturities, call features, and other differences, but it would alleviate most of the risk.