Interest Rate Swaps

An interest rate swap is a contract between two parties to exchange all future interest rate payments forthcoming from a bond or loan. It's negotiated between corporations, banks, or investors. Swaps are derivative contracts. The value of a swap is derived from the underlying value of the two streams of interest payments.

Swaps are like exchanging the value of the bonds without going through the legalities of buying and selling actual bonds. Most swaps are based on bonds that have adjustable-rate interest payments that change over time. Swaps allow investors to offset the risk of changes in future interest rates.

Example

The most common is the "vanilla swap." It occurs when one party swaps an adjustable-rate payment stream with another party's fixed-rate payments.

There are a few terms used:

• The receiver or seller swaps the adjustable-rate payments. The payer swaps the fixed-rate payments.
• The notional principle is the value of the bond. It must be the same size for both parties. They only exchange interest payments, not the bond itself. 
• The tenor is the length of the swap. Most tenors are from one to several years. The contract can be shortened at any time if interest rates go haywire.
• Market makers or dealers are the large banks that put swaps together. They act as either the buyer or seller themselves. Counterparties only have to worry about the creditworthiness of the bank and not that of the other counterparty. Instead of charging a fee, banks set up bid and ask prices for each side of the deal. In the past, receivers and sellers either found each other or were brought together by banks. These banks charged a fee for administering the contract.

The net present value (NPV) of the two payment streams must be the same. That guarantees that each party pays the same over the length of the bond.

The NPV calculates today's value of all total payments. It's done by estimating the payment for each year in the future for the life of the bond. The future payments are discounted to account for inflation. The discount rate also adjusts for what the money would have returned if it were in a risk-free investment, such as Treasury bonds.

The NPV for the fixed-rate bond is easier to calculate, because the payment is the same each year. The adjustable-rate bond payment stream, however, is typically based on a reference rate, which can change. Based on what they know today, both parties have to agree on what they think will probably happen with interest rates.

One common benchmark rate was the London Interbank Offered Rate (LIBOR), which was the interest rate that banks charged each other for short-term loans. Many market makers have transitioned to another reference rate, now that LIBOR has been retired as a benchmark for new loans.

The shift, which is very slow and complex, is intended as a reference rate reform. A different rate, called the Secured Overnight Funding Rate (SOFR), has taken the place of USD LIBOR.

There may be some uncertainty for interest rate swaps during the transition, since the two rates are not a one-for-one switch. Therefore, regulators are encouraging the use of fallback language in contracts so that all parties understand the valuation differences between LIBOR and the new reference rate.

Advantages

In a swap, the adjustable-rate payment is tied to a benchmark rate. The receiver may have a bond with low-interest rates that are barely above the benchmark rate, but it may prefer the predictability of fixed payments, even if they are slightly higher. Fixed rates allow the receiver to forecast its earnings more accurately. 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.

Banks need to match their income streams with their liabilities. Banks make a lot of fixed-rate mortgages. Since these long-term loans aren’t paid back for years, the banks must take out short-term loans to pay for day-to-day expenses. These loans have floating rates. For this reason, the bank may swap its fixed-rate payments with a company's floating-rate payments. Since banks get the best interest rates, they may even find that 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 seek to lower payments that are closer to the benchmark rate. It expects rates to stay low so it is willing to take the additional risk that could arise in the future.

Similarly, the payer would pay more if it were to take 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.

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 with 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. But if they lose, they can upset overall market functioning by requiring a lot of trades at once. 

Example

1. Country Bank pays Town Bank payments based on an 8% fixed rate.
2. Town Bank pays Country Bank a benchmark rate plus 2%.
3. The tenor is for three years with payments due every six months.
4. Both companies have a notional principal of $1 million.

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

Effect on the U.S. Economy

According to the Bank for International Settlements, there are $524 trillion in loans and bonds that are involved in swaps. This is by far the bulk of the $640 trillion over-the-counter derivatives market. It's estimated that derivatives trading is worth more than $600 trillion. This is 10 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 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.

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

​In-Depth: Subprime Crisis Causes | Derivatives' Role in 2008 Crisis | LTCM Hedge Fund Crisis

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