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I am trying to understand what it means for an interest swap to be collateralized.

If for example, I am paying fixed to a bank and receive floating in return. Who is giving collateral to whom? and how is the amount of collateral calculated?

I read that: "swaps are collateralized at the onset and then collateral is called up or down depending of changes in the market value of the swap". Don't really understand what this means and I would appreciate an example.

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I am out of touch with the movement towards centralised counterparties, but I assume that the basic principles are similar to when I looked at it.

All derivatives have a risk measure like a daily Value-at-Risk (VaR) associated with them, as well as a net present value (NPV). The fact that it is a swap does not matter; all derivatives will be covered by the same collateral agreement.

The VaR/NPV is calculated using an accepted methodology by both parties. The counter-parties then post accepted collateral in an amount that covers the worst case of the NPV moving against them by the risk measure. (In the case of central clearing, both sides post collateral to the central clearer.) E.g., if the NPV of the counterparty is +\$2 million, but the daily risk is \$10 million, they need to have at least \$8 million in collareral.

This way, if one side fails, the other side can seize collateral to make up for the value of the derivatives position.

In the pre-central clearing days, in the case that a dealer is dealing with an entity that is hedging interest rates, but does not otherwise trade derivatives, the dealer typically sets the terms on how collateral works unilaterally (e.g., the dealer does not post collateral). Banks are in the business of assessing and managing credit risk, so they can handle the credit risks associated with swaps relatively easily. I do not know whether this pattern of behaviour is still allowed under central clearing.

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I can clarify a few points that @Brian Romanchuk raised. Nowadays newly transacted US$ interest Rate swaps must be cleared at a clearing house, unless the client claims an exemption (for example, corporates utilizing IRS for hedging purposes are usually eligible for an exemption).

The clearing house sets two kinds of collateral requirements (1) initial margin , which is calculated at the portfolio level ,the amount of which is in proportion to the riskiness of a client’s portfolio of swaps and (2) variation margin , the amount of which moves every day as the market value of the swap moves. For example , a swap has zero market value at initial execution by definition. But, if you have received the fixed rate, and the market for the fixed rate goes up the following day , the exchange will demand extra variation margin to be settled immediately. If you have done a swap with 10k per 0.01% risk and the fixed rate goes up by 0.10%, they will demand 100k for example.

These flows are basically the same as in the pre Dodd-Frank era when clients would face banks directly.

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