1. What is an interest rate swap?

An interest rate swap is a derivatives transaction. It is a contract in which two counterparties commit to exchange, over an agreed period of time, two streams of interest payments, with the interest payments based on the same notional amount but calculated with reference to different interest rate benchmarks. There is no exchange of principal, only an exchange of cash flows associated with the interest payments.

1. How is a Dealer Member's principal position in an interest rate swap margined?

Inventory margin is required on both the floating rate and fixed rate payments for any principal position in an interest rate swap. The applicable margin rate is the rate that would apply to securities prescribed in section 5210 (i.e. Government of Canada bond of the same maturity categories). There is an additional premium on the fixed rate payments of 25% of the margin that would otherwise apply. The floating interest rate must be reset at least every 90 days. In effect, the Dealer Member (Dealer) provides an aggregate margin on the fixed and floating rate payments (refer to Appendix 1 for example).

1. Are offsets allowed for interest rate swaps?

Section 5680 allows for swap position offsets. An offset is allowed for an interest rate swap with a matching notional amount of principal and margin rate category, but with a cash flow exchange opposite to the original swap.

A Dealer may offset the cash flows from a short (or long) position such as a Government of Canada bond against the receipt (or payment) of fixed rate cash flows, provided the Government of Canada bond has the same principal amount and margin rate category as the swap. Similarly, a floating rate offset is available whereby the Dealer can offset the cash flows from a short (or long) position in a Government of Canada bond or domestic bank paper with less than one year to maturity against the receipt (or payment) of floating rate cash flows. The offset may also be applied to United States dollar payments and security positions denominated in the same currency.

1. How is a Dealer's client position in an interest rate swap margined?

The counterparty to the swap is considered the Dealer's client. No margin is required in respect of an interest rate swap entered into by a client which is an acceptable institution as defined in Form 1. For acceptable counterparties (AC) as defined in Form 1, the margin requirement is based on the market deficiency calculated in respect of the transaction on an item by item basis. For example, margin equal to the difference in market value between a Government of Canada bond and Government of Canada Treasury bill is required in a case where the parties exchanged the cash flows resulting from this transaction.

1. What is the market value deficiency?

The market value deficiency or "mark to market" of an interest rate swap involves comparing the present values of the fixed rate and floating rate notional principals at interim time periods. As interest rates for equivalent term swaps change over time, the "value" of any swap will change. If this value is a loss to the client, they are required to provide the deficiency as margin.

1. How is the market value deficiency calculated?

The market value deficiency is calculated as the present value of the difference between fixed rate payments at the agreed interest rate and fixed rate payments at the current market rate. The interest rate used to present value this difference is the rate for equivalent term swaps. Additionally, an adjustment must be made to reflect any interest accrued up to this mark to market date (see Appendix 1 for example).

1. Applicable Rules

IIROC Rules this Guidance Note relates to:

• section 5440, and
• section 5680.

1. Previous Guidance Note

This Guidance Note replaces C-110 - Interest Rate Swaps.

1. Related documents

This Guidance Note was published under Notice 21-0190 - IIROC Rules, Form 1 and Guidance.

1. Appendices

Appendix 1 – Example of interest rate swap

Details of interest rate swap agreement

Assumptions

 Margin requirements

Market deficiency calculation:

Three months into the agreement, the market has changed and the Dealer must mark-to- market this swap. Current market interest rate for fixed term interest rate swaps (4 years and 9 months) is 11.50%. The Bankers Acceptance rate is reset to current market rate and therefore requires no mark to market.

Part 1

Part 2

In this example, the current market interest rate has risen, therefore, the fixed rate (in this case, the client) has a loss. Netted against this loss is the client's right to receive the $6,233 accrued interest.