Interest Rate Swap

What is an Interest Rate Swap?

An interest rate swap is a swap contract between two parties agreeing to exchange cash equal to their interest rates. The goal of an interest rate swap is to obtain a lower interest rate or one that better suits each party, at least better than what would have been possible without the swap. Interest rate swaps are a form of derivative contracts that are traded over the counter (OTC). 

OTC refers to how securities are dealt with through a broker, usually a swap dealer, instead of a consolidated exchange. OTC trading can involve equities, debt, and derivatives. The most common swaps are plain traded "vanilla" swaps, which exchange a fixed for a floating rate such as LIBOR. Several other swaps will be mentioned later in the article; fixed rate for floating rate makes up the majority of all swap agreements.  

LIBOR: What is it?

The London Interbank Offered Rate (LIBOR) is the global benchmark for interest rates that allow banks to borrow from one another. The rate is calculated and published each day by the Intercontinental Exchange (ICE). ICE will continue publishing LIBOR until June 30, 2023, after which it will be discontinued due to recent scandals, manipulations, and legitimacy issues. To read more about the LIBOR scandal and how it may have affected you, please follow this article: LIBOR Scandal. The phase-out began on December 31, 2021, with the one-week and two-month US Dollar (USD) rates being phased out first. 

LIBOR is based on five different currencies, the US Dollar, the Euro, the British Pound, the Swiss Franc, and the Japanese Yen, and has seven different maturities. The maturities are overnight/spot next, one week, one month, two months, three months, six months, and 12 months. Combining the five different currencies and seven different maturities allows banks to work with 35 different LIBOR rates. The most common out of the 35 is the US three-month dollar rate. 

Every day, ICE receives information from global central banks which play a significant role in the London market, on how much they charge for short-term loans. ICE gathers those details, arranges them, takes out the highest and lowest values, and calculates the remaining numbers to get an average. 

Discarding the largest and smallest values allows for better distribution of numbers by taking out any outliers. The average used is called the truncated mean or trimmed mean. The LIBOR rate is calculated for each currency and rate and published each morning. 

Different Types of Interest Rate Swaps

An Interest Rate Swap can be structured in a variety of ways:

  • Fixed for floating
  • Floating for fixed 
  • Floating for floating 

Fixed for Floating Swap

A fixed rate for floating rate is an IRS, where one party feels that interest rates are going to rise but currently has exposure to floating rate liabilities, and the other party feels that interest rates are going to fall, but has exposure to fixed rate liabilities. Both parties will then reach an agreement to swap their interest cash flows, so they get the interest rate better suited to their expectations. Let's look at an example to understand this better.

Company A carries a $150 million loan at a fixed rate of 7.5%. It expects that the interest rates are going to fall, and wants to pay a floating rate. Company B on the other hand, carries a $150 million loan at LIBOR + 3.0%, which is a floating rate, and expects a different future outlook. It believes that interest rates will rise, and wants to pay a fixed rate. 

The best and easiest way for companies to obtain their desired interest rate exposures is to swap their interest payments. In the fixed rate for floating rate swap, Company A pays the floating rate, and will benefit if interest rates fall, and Company B pays the fixed rate, and will benefit if interest rates rise.

Floating for Fixed Swap

A floating  to fixed swap is usually entered into by a company that has no access to fixed rates. It can get a fixed rate loan by borrowing from a bank at a floating Rate, then entering into this swap where they get a fixed rate. The company that had no access to a fixed rate loan can now borrow from the bank at a fixed rate. 

Floating for Floating Swap

Floating for floating swap also called a basis swap, is a type of swap agreement in which two parties agree to swap variable interest rates based on different money market rates. This swap is usually entered into to limit the amount of interest rate expense that a company may incur as a result of different lending and borrowing rates. The following example illustrates this concept better.

A company borrows money at the Treasury Bill (T-Bill) rate, but is also lending money to another company at LIBOR. A T-Bill is a short-term US government securities backed by the US Department of the Treasury. The company currently has exposure to two floating rates, i.e., the T-Bill rate and LIBOR. As a result, it is exposing itself to interest rate risk due to the mismatch on its rate exposure. The company can enter into a floating for floating rate swap by exchanging their T-Bill rate for LIBOR. Once the exchange is completed the company will be borrowing money at LIBOR and lending money at LIBOR, eliminating interest rate risk.

What is a Swap Dealer?

Under Dodd-Frank, a swap dealer (SD) is defined as any person who makes a market in swaps or holds themself out as a dealer in swaps. 

interest rate swap

The term swap dealer technically means any person who:

  • Holds themself out as a dealer 
  • Makes a market in swaps
  • Regularly enters into swaps with counterparties as a form of business
  • Engages in any swap activity at a level where the person becomes known in the trade as a dealer or market maker

Firms are exempt from SD registration if they meet the following basis of de minimis. De minimis is the total gross amount an organization enters into during one year of trading activities, and the current de minimis cap in the US is $8 billion. 

All registered swap dealers must be NFA members. NFA is the regulatory entity for the United States derivatives industry. 

Interest Rate Swaps: History

In 1981, IBM and the World Bank made the first official currency swap. Although similar transactions were done before 1981 in the United Kingdom, this is the major one that started it all. The World Bank was looking to borrow German marks and Swiss francs for future endeavors, but it was at a time where there were restrictions in those countries from borrowing. At the same time IBM, which held a substantial amount of German marks and Swiss Francs needed US dollars. At the time, US interest rates were high, and the World Bank had US dollars. The two parties would swap their currencies, the World Bank would receive the needed marks and francs, while IBM would receive the required US dollars. Since this swap has taken place, it has grown into an extraordinary market instrument accounting for billions if not trillions of dollars worth of transactions. 

Interest Rate Swap Risks

There are several risks inherited with Interest Rate Swaps. The most significant risk with them arises due to the fact that it exposes the participants to interest rate risk. Interest rates are constantly changing even during the tenor of the swap (especially observable in the floating side of the swap). If one party chooses to swap for fixed rates, but rates actually fall, they would have been better off keeping their original payment. This is also referred to as delta risk. 

Delta is a term used in trading to analyse the change in the price of a derivative compared to the difference in cost of the underlying asset. Delta is one of the five technical risk ratios. These swaps also have gamma risk. Gamma is a term used in trading to assess the rate of change of the delta of an asset relative to the difference in the asset's price and is used to analyze the movement of derivatives relative to the underlying value. 

These swaps are also subject to the counterparty's credit risk. Credit risk is the chance that the counterparty entity on the swap will default on their payment obligation. Credit risk has diminished since the 2007-2008 financial crisis, where a lot of the swap contracts go through central clearing counterparties (CCP), also referred to as a central counterparty. CCPs are financial institutions that take on counterparty credit risk between parties during a transaction. CCPs provide services in foreign exchange, securities, options, and derivative contracts. Although most credit risk has been alleviated, they still pose some risk compared to T-Bills. 

How To Invest in Interest Rate Swaps

These swaps have become a necessary action for many investors, corporate treasurers, risk managers, and banks in recent times. There are many uses for them, some of which include: 

Portfolio Management

Portfolio managers can adjust interest rate exposure with these swaps to offset the risks of interest rate volatility in their portfolios. They can increase or decrease their interest rate exposure with these swaps on the yield curve. Managers can hedge their position by increasing or decreasing their direction with yield curve changes, and returns are generated with a swap on different maturity dates. 

The longer the term to maturity on an interest rate swap, the greater its sensitivity to interest rate changes. Long-term interest rate swaps can increase the duration of a portfolio, making them an effective tool in liability investing, where managers aim to match the duration of assets with that of long-term liabilities.

Speculation

Interest Rate Swaps do not require a lot of upfront capital. Hence, they give fixed-income traders a way to speculate. Speculation is a term used to describe forming a theory or opinion without firm evidence. Speculative trading aims to gain big profits from betting on future market movements or spreads. 

For example, to speculate that ten-year rates will fall using cash in the Treasury market, a trader must invest some money or borrowed capital to buy a ten-year Treasury note. However, the fixed income trader could receive a fixed ten-year through a swap, which still hedges against interest rate volatility. 

Corporate Finance and Risk Management

Firms could enter into swaps if they believe interest rates will fall or rise. If the firm thinks interest rates will increase and currently has floating rates, they can enter into a swap where they pay fixed and receive floating. The opposite is also true, where if the firm believes that rates will fall and currently has fixed rates, they can enter into a swap where they pay floating and receive fixed. 

Financial institutions have a lot of their fixed and floating interest rate exposure canceling out, but if not, a financial institution can enter into a swap where it counterbalances any interest rate risk. 

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