DEFINITION of Fixed Price
The fixed price leg of a swap is one that is based on an unchanging interest rate. A plain vanilla interest rate swap is an exchange of two streams of cash flows. Both streams are based on the same amount of notional principal, but one stream pays interest on that notional principal at a fixed rate (or fixed price) and one stream pays interest on the notional principal at a floating or variable rate. This is also known as a fixed-for-floating swap. The fixed price leg is that one which entails the fixed rate.
A fixed-for-fixed swap can occur in an exchange between two currencies where both legs carry a fixed interest rate.
BREAKING DOWN Fixed Price
An interest rate swap is a type of financial contract that allows one party to pay (or receive) a fixed interest payment on some underlying notional value while the other receives (or pays) a variable interest rate on the same underlying value. These swaps may be entered for several reasons, such as converting an existing fixed rate payment into a variable rate payment (or vice versa), to hedge against specific interest rate risks, or to speculate on the future direction of interest rates. A typical interest rate swap is thus a fixed-for-floating swap.
The fixed price leg carries a fixed rate stream of cash flows that does not change for the duration of the swap, while the floating (variable) rate stream changes periodically over the duration of the swap as its benchmark interest rate, often referenced to LIBOR, changes in accordance with market conditions. Two parties, called counterparties, enter into such transactions to reduce their exposure to changes in interest rates or to attempt to profit from changes in interest rates.
The fixed price leg will essentially freeze the cash flows attached to some underlying value at a fixed rate for the life of the contract. If a trader or firm believes that interest rates are low (say at 1.50%) and will rise in the future, they may enter a swap as the pay-fixed counterparty so that they will continue to pay just 1.50% even if interest rates rise. Likewise, a trader or firm who thinks that interest rates are high (say at 6%) and are likely to fall may enter a swap as the receive-fixed counterparty so that they will still receive 6% even when rates are lower.
Many currency swaps, which involve the receipt and redelivery of a specified amount of foreign currency in exchange for another, carry two fixed price legs, since they are often looking to hedge foreign currency risk and not want to expose themselves to additional interest rate risk.