Interest Rate Swaps

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Interest rate swaps are the popular derivative. Photo: Real Life/Getty Images

Definition: An interest rate swap is a contract between two counter-parties who agree to exchange the future interest rate payments they make on loans or bonds. These two counterparties are usually banks, businesses, hedge funds, or investors.  

The so-called vanilla swap is by far the most common. That's when a counter-party swaps floating-rate payments with another counterparty's fixed-rate interest payments.

The floating rate payment is usually tied to LIBOR, which is the interest rate banks charge each other for short-term loans. (LIBOR is itself based on the Fed funds rate.) A smaller number of swaps are between two counter-parties with floating-rate payments.

Explained

To make it easier to explain, the counterparty that wants to swap its floating-rate payments, and receive fixed-rate payments, is called a receiver or seller. The counterparty that wants to swap its fixed-rate payments is the payer.  

The counterparties usually are making payments on loans or bonds of the same size. This is called the notional principle. In a swap, they only exchange interest payments, not the bond itself. 

In addition, the present value of the two payment streams must also be the same. That means that, over the length of the bond, each counterparty will pay the same amount. That's easy to calculate with the fixed-rate bond, because the payment is always the same.

It's more difficult to predict with the floating rate bond, since the payment stream is based on LIBOR, which can change. Therefore, both parties have to agree on what they think will probably happen with interest rates, based on what they know today. 

A typical swap contract lasts for one to fifteen years--this is known as the tenor.

The counterparty can terminate the contract earlier if interest rates go haywire. However, they rarely do in real life. (Source: Understanding Interest Rate Swap Math and PricingCalifornia Debt and Investment Advisory Commission)

In the past, receivers and sellers either found each other, or were brought together by investment and commercial banks that charged a fee for administering the contract. In the modern swap market, large banks act as market makers, or dealers. This means they act as the either the buyer or seller themselves. Counterparties only have to worry about  the credit worthiness of the bank, not the other counterparty. Instead of charging a fee, banks set up bid and ask prices for each side of the deal. (Source: What Are Interest Rate Swaps and How Do They Work? PIMCO, January 2008)

Example

  1. ACME Anvil Co. pays ACME Catapult Corp. 8% fixed.
  2. ACME Catapult pays ACME Anvil the rate on a six-month Treasury bill +2%
  3. The tenor is for 3 years, with payments due every six months.
  1. Both companies have a Notional Principle of $1 million.
PeriodT-Bill RateACME Catapult Corp. PaysACME Anvil Co. Pays
04%  
13%$30,000$40,000
24%$25,000$40,000
35%$30,000$40,000
47%$35,000$40,000
58%$45,000$40,000
6 $50,000$40,000

(Source: Interest Rate Swap,  New York University, Stern School of Business, 1999)

Advantages of Interest-Rate Swaps

The receiver may have a bond with low interest rates, barely above LIBOR, but is seeking the predictability of fixed payments, even if they are slightly higher. This business can then forecast its earnings more accurately, and this elimination of risk will often boost its stock price. The stable payment stream allows the business to have a smaller emergency cash reserve, which it can plow back into its business.

Banks need to match their income streams with their liabilities. Banks typically make a lot of fixed-rate mortgages. Since these long-term loans don't get paid back for years, the banks must take out short-term loans to pay for day-to-day expenses. These are usually floating-rate. Therefore, the bank may swap its fixed-rate payments with a company's floating-rate payments.  Since banks typically get the best interest rates, it may even find the company's payments are higher than what the bank owes on its short-term debt. That's a win-win for the bank.

The payer may have a bond with higher interest payments, and is seeking to lower payments that are closer to LIBOR. He expects rates to stay low, so is willing to take the additional risk that they could rise in the future. (Source: Interest Rate Swaps ExplainedMoneyCrashers.com)

Similarly, the payer would pay more if it just took out a fixed-rate loan. In other words, the interest rate on the floating-rate loan plus the cost of the swap is still cheaper than the terms it could get on a fixed-rate loan. (Source: Interest Rate Swaps:How Does It work?, ABN-AMRO, May 2014)

Disadvantages

Hedge funds and other investors use interest rate swaps to speculate. They may increase risk in the markets because they use leverage accounts that only require a small down-payment. They offset the risk of their contract by another derivative. That allows them to take on more risk, because they don't worry about having enough money to pay off the derivative if the market goes against them. If they win, they cash in. However, if they lose, they can upset the overall market functioning by requiring a lot of trades at once. 

Effect on U.S. Economy

There are $421 trillion in loans and bonds that are involved in swaps. This is by far the bulk of the $692 trillion OTC derivative market. It's estimated that derivatives trading is worth $600 trillion -- ten times more than the total economic output of the entire world. In fact, 92% of the world's 500 largest companies use them to lower risk. For example, a futures contract can promise delivery of raw materials at an agreed-upon price. This way the company is protected if prices rise. They can also write contracts to protect themselves from changes in exchange rates and interest rates. (Source: NYT, Bank Face New Checks on Derivative Trading, January 3, 2013;  Table 19: Amounts Outstanding of OTC DerivativesBank for International Settlements, June 2014.)

Like most derivatives, these contracts are over-the-counter. Unlike the bonds that they are based on, they are not traded on an exchange. As a result, no one really knows how many exist, or what their impact is on the economy.  

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