What is Interest Rate Swaps?

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We look at Interest Rate Swaps in detail in this article, along with examples –

Learn more about Swaps, valuation, etc. in this detailed Swaps in FinanceSwaps In FinanceSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.read more

Interest Rate Swaps Example

Let’s see how an interest rate swap works with this basic example.

Let’s say Mr. X owns a $1,000,000 investment that pays him LIBOR + 1% monthly. LIBOR stands for London interbank offered rate and is one of the most used reference rates in the case of floating securities. The payment for Mr. X keeps changing as the LIBOR keeps changing in the market. Now assume there is another guy Mr. Y who owns a $1,000,000 investment that pays him 1.5% every month. His payment never changes as the interest rate assumed in the transaction is fixed in nature.

Now Mr. X decides he doesn’t like this volatility and would rather have fixed interest payments, while Mr. Y explores a floating rate to have a chance of higher payments. This is when both of them enter into an interest rate swap contract. The terms of the contract state that Mr. X agrees to pay Mr. Y LIBOR + 1% every month for the notional principal amount of $1,000,000. Instead of this payment, Mr. Y agrees to pay Mr. X a 1.5% interest rate on the same principal notional amount. Now let us see how the transactions unfold under different scenarios.

Scenario 1: LIBOR standing at 0.25%

Mr. X receives $12,500 from his investment at 1.25% (LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more standing at 0.25% and 1%). Mr. Y receives a fixed monthly payment of $15,000 at a 1.5% fixed interest rate. Under the swap agreement, Mr. X owes $12,500 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions partially offset each other. The net transaction would lead Mr. Y to pay $2500 to Mr. X.

Scenario 2: LIBOR standing at 1.00%

Mr. X receives $20,000 from his investment at 2.00% (LIBOR standing at 1.00% and 1%). Mr. Y receives a fixed monthly payment of $15,000 at a 1.5% fixed interest rate. Under the swap agreement, Mr. X owes $20,000 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions partially offset each other. The net transaction would lead Mr. X to pay $5000 to Mr. Y.

So, what did the interest rate swap do to Mr. X and Mr. Y? The swap has allowed Mr. X a guaranteed payment of $15,000 every month.  If LIBOR is low, Mr. Y will owe him under the swap. However, if the LIBOR is high, he will owe Mr. Y. Either way, he will have a fixed monthly return of 1.5% during the tenure of the contract. It is very important to understand that under the interest rate swap arrangement, parties entering into the contract never exchange the principal amount. The principal amount is just notional here. There are many uses to which the interest rate swaps are put, and we will discuss each later in the article.

The trading perspective of interest rate Swap

Interest rate swaps are traded over the counterCounterOver the counter (OTC) is the process of stock trading for the companies that don’t hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments.read more, and generally, the two parties need to agree on two issues when going into the interest rate swap agreement. The two issues under consideration before a trade are the swap’s length and the swap’s terms. The swap’s length will decide the contract’s start and termination date of the contract, while the terms of the swap will decide the fixed rate on which the swap will work.

Uses of interest rate swap

  • One of the uses to which interest rate swaps are put is hedging. In case an organization is of the view that the interest rate would increase in the coming times, and there is a loan against which they are paying interest. Let us assume that this loan is linked to 3 monthly LIBOR rates. If the organization believes that the LIBOR rate will shoot up in the coming times, the organization can then hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an assetread more the cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more by opting for fixed interest ratesFixed Interest RatesA fixed interest rate is a constant rate of interest levied on debts like loans, mortgages, or bonds.read more using an interest rate swap. This will provide some certainty to the cash flow of the organization.The banks use interest rate swaps to manage interest rate risk. They tend to distribute their interest rate risk by creating smaller swaps and distributing them in the market through an inter-dealer broker. We will discuss this attribute and transaction in detail when we look at who are the market makers in the business.A huge tool for fixed-income investors. They use it for speculation and market creation. Initially, it was only for corporations, but as the market grew, people started perceiving the market as a way to gauge interest rate views held by the market participants. This was when many fixed-income players started actively participating in the market.The interest rate swap works as an amazing portfolio management tool. It helps in adjusting the risk related to interest rate volatility. In the case of fund managers who want to work on a long-duration strategy, the long-dated interest rate swaps help increase the portfolio’s overall duration.

What is the swap rate?

Now that you have understood what a swap transaction is, it is very important to understand what is known as the ‘swap rate.’ A swap rate is the rate of the fixed leg of the swap as determined in the free market. So, the rate quoted by various banks for this instrument is known as the swap rate. This provides an indication of the market’s view, and if the firm believes it can stabilize cash flows by buying a swap or can make a monetary gain doing so, they go for it. So, the swap rate Swap Rate Swap rate refers to the fixed exchange rate of a swap contract as ascertained by the parties or the market. The rate is inclusive or exclusive of the spread and determined on the benchmark rates such as LIBOR or MIBOR.read more is the fixed interest rate that the receiver demands in exchange for uncertainty, which exists because of the floating leg of the transaction.

What is a swap curve?

The plot of swap rates across all the available maturities is known as the swap curve. It is very similar to the yield curve of any country where the prevailing interest rate across the tenure is plotted on a graph. Since the swap rate is a good gauge of the interest rate perception, market liquidity, and bank creditBank CreditBank credit is usually referred to as a loan given for business requirements or personal needs to its customers, with or without a guarantee or collateral, with an expectation of earning periodic interest on the loan amount. The principal amount is refunded at the end of loan tenure, duly agreed upon, and mentioned in the loan covenant.read more movement, the swap curve in isolation becomes very important for the interest rate benchmark.

source: Bloomberg.com

Generally, the sovereign yield curve and swap curve are of similar shape. However, at times there is a difference between the two. The difference between the two is known as ‘swap spread.’ Historically this difference tended to be positive, which reflected higher credit risk with the banks compared to a sovereign. However, considering other factors indicative of supply-demand liquidity, the U.S. spread currently stands at negative for longer maturities. Please refer to the graph below for a better understanding.

Please refer to the graph below for a better understanding.

The swap curve is a good indicator of the conditions in the fixed income market. It reflects the bank credit situation and the large interest rate view of the market participants. In mature markets, the swap curve has supplanted the treasury curve as the main benchmark to price and trade corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value.read more and loans. It is a primary benchmark in certain situations as it is more market-driven and considers larger market participants.

Who are the market makers in Swaps?

Big investment firms, along with commercial banks that have strong credit rating history, are the largest swap market makers. They offer fixed and floating rate options to investors who want to go for a swap transaction. The counterparties in a typical swap transaction are generally corporations, banks, or investors on one side and large commercial banks and investment firms on the other. In a general scenario, the moment a bank executes a swap, it usually offsets it through an inter-dealer broker. The bank keeps the fees for initiating the swap in the whole transaction. In cases when the swap transaction is very large, the inter broker-dealerBroker-dealerA broker-dealer is a person or company that trades and executes financial securities, stocks, commodities, or derivatives for itself or on behalf of its customers, for which it charges a commission as its main source of income.read more may arrange several other counterparties, spreading the risk of the transaction. This results in a wider dispersionDispersionIn statistics, dispersion (or spread) is a means of describing the extent of distribution of data around a central value or point. It aids in understanding data distribution.read more of the risk. This is how banks that hold interest rate risk try to spread the risk to the larger audience. The role of the market makers Market Makers Market makers are the financial institution and investment banks which ensures enough amount of liquidity in the market by maintaining enough trading volume in the market so that trading can be done without any problem.read more is to provide ample players and liquidity in the system.

What are the risks involved in Swaps?

Like in the case of a non-government fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.read more market, an interest rate swap holds two primary risks. These two risks are interest rate risk and credit risk. Credit risk in the market is also known as counterparty risk. The interest rate risk arises because the expectation of the interest rate view might not match the actual interest rate. A Swap also has a counterparty risk, which entails that either party might adhere to contractual terms. The risk quotient for interest rate swaps came to an all-time high in 2008 when the parties refused to honor the commitment of interest rate swaps. It became important to establish a clearing agency to reduce counterparty riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract.read more.

What is in it for an investor in the swap?

Over the years, financial markets have constantly innovated and come up with great financial products. Each of them initiated in the market intending to solve some corporate-related problem and later became a huge market. This has exactly happened with interest rate swaps or the swap category at large. The objective for the investor is to understand the product and see where it can help them. Understanding the interest rate swap can help an investor gauge an interest rate perception in the market. It can also help an individual decide on when to take a loan and when to delay it for a while. It can also help to understand the kind of portfolio your fund manager is holding and how over the years, they are trying to manage the interest rate riskInterest Rate RiskThe risk of an asset’s value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more in the market. Swap is a great tool to manage your debt effectively. It allows the investor to play around with the interest rate and does not limit him to a fixed or floating option.

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