An interest rate swap is a financial derivative that involves the exchange of interest rate cash flows between two parties. This swap can be broken down into two legs: a fixed leg and a floating leg. The fixed leg of an interest rate swap can be priced as a coupon-paying bond. A coupon-paying bond is a type of bond that includes periodic interest payments to the bondholder, in addition to the repayment of the principal amount at maturity. The floating leg of an interest rate swap is equivalent to a floating-rate note (FRN). An FRN is a type of debt instrument that has a variable interest rate. The interest rate of an FRN is typically tied to a benchmark, such as a treasury bill rate or the London Interbank Offered Rate (LIBOR), and adjusts at specified intervals. Therefore, the floating leg of an interest rate swap, which also has a variable interest rate, can be equated to an FRN.

Choice A is incorrect. The fixed leg of an interest rate swap cannot be equivalent to a floating-rate note as it involves payment of a fixed interest rate, not a variable one.

Choice C is incorrect. The fixed leg of an interest rate swap cannot be equivalent to a zero-coupon bond because the latter does not involve periodic interest payments, unlike the former which involves regular fixed payments.

Choice D is incorrect. This choice incorrectly suggests that both legs of the swap are floating, which contradicts the basic structure of an interest rate swap where one leg is typically fixed and the other floating.

Things to Remember

• Interest rate swaps are commonly used to manage interest rate risk by exchanging fixed interest rate payments for floating rate payments, or vice versa.

• The fixed leg of an interest rate swap is typically based on a fixed interest rate, such as a coupon-paying bond.

• The floating leg of an interest rate swap is typically based on a variable interest rate, such as a floating-rate note tied to a benchmark rate.

• Interest rate swaps are OTC (over-the-counter) derivatives, meaning they are traded directly between two parties without going through an exchange.

• Counterparty risk is an important consideration in interest rate swaps, as it involves the risk that one party may default on its obligations.