Interest Rate Swaps in DeFi
What is Interest Rate Swaps?
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Last week on the fixed interest rate, we covered zero coupon bond. The coupon is paid upfront or at maturity and divided equally per month.
Another method to get a fixed interest rate is via Interest Rate Swap. That is what we will focus in this article today.
What's Interest Rate Swap?
Swap is a financial derivative product consisting of 2 transacting parties making a series of payments to the other in a certain period.
As you can imagine, it is to swap the interest rate. We exchange the interest rates.
E.g. I have an asset that has a changing interest rate. It pays me 3%, 2%, 3.5%, 0.17%, 4.2%. Instead, I want it to give me a consistent 2% instead.
How do we do this? Via interest rate swaps.
Why do we want this? Because we prefer something stable and consistent. It helps with financial management.
Types of Swaps
There are 4 kinds of swaps based on underlying asset properties: Currency swap, Interest rate swap, Equity swap and commodity swap.
The interest rate swap has 2 transacting parties performing a series of interest payments to the other. Both payments are in the same currency. One party pays floating interest, the other can pay at a floating or fixed rate.
Note: you only swap the interest rate. Not the asset itself.
In this analysis, we focus on the interest rate swap, which has one side paid by paying the float interest rate. The other side is paid by the fixed interest rate. This also is called a Plain Vanilla Swap.
Swaps have a
interest payment period
As a future contract, swaps do not have any party prepayment. So swaps have an initial value = 0. That means present value (PV) is the same. The date which payment occurs called settlement date and the time interval between two payments is called a payment cycle.
Payments will usually occur for a short period of time, usually 1 day. This is because floating rates often change continuously, so payments will have to be made within the specified time.
Each Swap is materialised by a transaction amount called estimated capital. Because Interest Rate Swaps include the payment of interest, the settlement of which is calculated by multiplying the period of the interest by the initial capital which is never paid out. Therefore, it is not called the initial capital but rather the estimated capital.
What Else Did You Miss?
Direct Collateralised Swap
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TLDR: When it comes to fixed interest rates, it is the interest rate swap and the variable interest rate. Because of this, you can see that projects will often do the fixed interest rate and interest rate swap/market.
Get smart: DeFi's current situation is yet to meet that demand, but this could be the starting point for DeFi's fixed-rate and swap-rate segment.
Ps: Order the textbook "Economics and Math of Token Engineering and DeFi" today!