What Is an Index Amortizing Swap (IAS)?
An index amortizing swap (IAS), also known as an amortizing interest rate swap, is a type of interest rate swap agreement in which the principal amount is gradually reduced over the life of the swap agreement. It is the opposite of an Accreting Principal Swap, in which the notional principal increases.
Typically, the reduction in the principal value is tied to a reference interest rate, such as the London Interbank Offered Rate (LIBOR).
- An index amortizing swap is a type of over-the-counter (OTC) derivative contract.
- It is similar to an interest rate swap agreement, in that it involves the exchange of cash flows based on fixed and variable rates of interest.
- Unlike regular interest rate swaps, IAS agreements involve a notional principal balance that declines over time. The rate of decline is linked to a reference interest rate, most typically LIBOR.
Understanding an Index Amortizing Swap (IAS)
Like any interest rate swap, IASs are over-the-counter (OTC) derivative contracts between two parties. One party wishes to receive a series of cash flows based on a fixed rate of interest, while the other party wishes to receive cash flows based on a floating rate of interest.
The difference between an IAS and a regular interest rate swap is that, in an IAS, the principal balance on which the interest payments are calculated can decrease over the life of the agreement. Typically, IASs will be indexed to LIBOR. In this situation, the principal will be reduced more rapidly when LIBOR declines, and less rapidly when LIBOR rises.
By convention, most IAS agreements use a starting notional principal value of $100 million, with a maturity period of five years and an initial lock-out period of two years. This means that the principal balance would only begin declining as of year three. Of course, because IAS agreements are OTC contracts, the exact terms can vary based on the needs of the parties involved.
It is important to note that the word "amortization" is used differently in this context than in its usual usage in finance. Here, amortization does not refer to the process of gradually paying off principal through a series of payments. Instead, it refers to a direct reduction of the notional principal amount that forms the basis for interest payments.
Some interest rate swaps allow the notional principal amount to either decrease or increase based on changes in a reference interest rate. These kinds of interest rate swaps are colloquially known as "roller-coaster swaps."
Real-World Example of an IAS
Emma is an institutional investor who decides to enter into an OTC IAS agreement. Under the terms of this agreement, Emma agrees to pay her counterparty a series of cash flows based on a fixed rate of interest. In exchange, her counterparty agrees to pay her cash flows based on a floating rate of interest, tied to LIBOR.
The notional principal for the IAS is set at $100 million, with an initial lock-out period of two years and a five-year term. Beginning in year three, the principal balance will reduce more rapidly if the reference rate, LIBOR, declines. On the other hand, it will decline more slowly if LIBOR rises.
As with standard interest rate swap agreements, there is no initial exchange of principal. Instead, the two parties swap net cash flows periodically throughout the life of the contract, depending on how interest rates evolve.