INDEX AMORTISING SWAP (IAS)
An interest rate swap whose principal amortises on the back of movements in an index, such as Libor or constant maturity treasuries. The fixed-rate receiver effectively grants an option to the fixed-rate payer to amortise the swap. The option is triggered by interest rate movements after an initial lock-out period. The notional principal amortises as rates fall or remains constant if rates remain the same. In return for granting the option, the fixed-rate receiver gets a yield above current fixed rates. IAS have been widely used by US regional banks in their asset/liability management activities. By using IAS, banks were able to obtain the negative convexity of a mortgage-backed security and avoid the risk of excessive prepayments due to changes in consumer sentiment. But the fixed receiver is exposed to both falling and rising rates. If rates fall, there is the possibility at each interest date that some or all of the swap will be terminated, creating a reinvestment risk. If rates rise, the swap may run to maturity, providing meagre income while floating rates soar.
An IAS fixed-rate receiver is selling volatility to the payer for an enhanced yield. So the lower the volatility of the index, the lower the option value and yield pick-up. A subsequent fall in volatility benefits the receiver because the likelihood that the swap will amortise decreases. IAS can be structured with negative or positive convexity and the amortisation schedules and lock-out periods can be changed in order to increase or decrease yields. Also known as an Indexed principal swap.