What Is a Fixed Price?
Fixed price can refer to a leg of a swap where the payments are based on a constant interest rate, or it can refer to a negotiated price point that is not subject to change under normal circumstances.
- Fixed price can refer to a leg of a swap where the payments are based on a constant interest rate, or it can refer to a negotiated price point that is not subject to change under normal circumstances.
- The fixed price leg of a swap is one that is based on an unchanging interest rate, whereas the floating price leg is calculated using variable interest rates.
- A contract is said to be a fixed price contract if the negotiated upon price is not allowed to vary unless there are certain, predefined, extenuating circumstances.
Understanding a 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 amount, while the other receives (or pays) a variable interest rate on the same underlying amount. 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, usually, a fixed-for-floating swap. The fixed price leg of a swap is one that is based on an unchanging interest rate, whereas the floating price leg is calculated using variable interest rates. There can also be a fixed-for-fixed swap, which is in an exchange between two currencies where both legs carry a fixed interest rate.
One of the most common types of interest rate swaps is the plain vanilla interest rate swap. This entails an exchange of two streams of cash flows where 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.
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.
Essentially, the fixed price leg freezes 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-the-fixed/receive-the-floating 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-the-fixed/pay-the-floating counterparty so that they will still receive 6% even if interest rates decline.
Many currency swaps, which involve the receipt and re-delivery 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 do not want to expose themselves to additional interest rate risk.
Fixed Price Contract
A contract is said to be a fixed price contract if the negotiated upon price is not allowed to vary unless there are certain predefined and extenuating circumstances. This is usually done so that the costs involved can be estimated with a reasonable amount of certainty. While this might be advantageous to one of the counterparties, an increase in costs would pose a risk to the other counterparty.