Definition
An interest rate swap is a contract between two parties to exchange all future interest payments resulting from a bond or loan. They are negotiated between companies, banks, and investors. Swaps are considered derivative instruments. The value of the swap is derived from the underlying value of the two interest payments.
Example
The most common is the “plain vanilla swap.” This occurs when one party exchanges a stream of variable payments for fixed interest payments from the other party.
Some terminology used: The second party or seller exchanges the variable payments. The first party exchanges the fixed payments. The default principal is the value of the bond. They must be of the same size for both parties. They are only exchanging interest payments, not the bond itself. The duration is the length of the swap. Most durations range from one year to several years. The contract can be shortened at any time if interest rates change significantly. Market makers or brokers are large banks that facilitate the swaps. They operate either as buyers or sellers themselves. The other parties need only to worry about the bank’s creditworthiness, not the other party’s. Instead of charging fees, banks set the bid and ask prices for each side of the swap. In the past, counterparties either found each other or were matched by banks. These banks charge fees to manage the contract.
Valuation
The net present value of both payments should be equal. This ensures that each party pays the same amount over the life of the bond.
The net present value of all total payments is calculated today. This is done by estimating the payments for each year in the future for the life of the bond. Future payments are discounted to account for inflation. The discount rate is also adjusted for what the money would have returned if it were in a risk-free investment, such as treasury bonds.
It is easier to calculate the net present value for a fixed-rate bond, as the payments are the same every year. However, the cash flow for a floating-rate bond typically depends on a benchmark rate that can change. Based on what they know today, both parties must agree on what they think is likely to happen regarding interest rates.
Benefits
In a swap, the variable payment is tied to a benchmark rate. A receiving party may have a bond with interest rates low enough to be nearly above the benchmark rate, but they may prefer the predictability of fixed payments, even if they are slightly higher. Fixed payments allow the recipient to forecast their earnings more accurately. This elimination of risk may increase stock prices. The stable cash flow allows the company to have a smaller emergency cash reserve, which it can reinvest.
Banks need to match income flows with their liabilities. Banks issue many fixed-rate loans. Since these long-term loans are not repaid for years, banks must take out short-term loans to cover day-to-day expenses. These short-term loans have variable rates. This is why a bank may swap fixed payments for variable payments with a company. Since banks get the best interest rates, they may find that the company’s payments are higher than what they owe on their short-term debts. This is a win for the bank.
A payor may have a bond with higher interest payments and wish to lower their payments closer to the benchmark rate. They expect rates to stay low, so they are willing to take on the additional risks that may arise in the future.
Similarly, a payor would pay a larger amount if they obtained a fixed-rate loan. In other words, the interest rate on the variable-rate loan plus the cost of the swap is still cheaper than the terms they could get on a fixed-rate loan.
Disadvantages
Using
Hedge funds and other investors engage in interest rate swap transactions for speculation. They may increase risks in the markets as they utilize leveraged accounts that only require a small initial payment.
They offset the risk in one contract with another derivative. This allows them to take on more risk as they do not worry about having enough money to settle the derivative if the market goes against them.
If they win, they make profits. But if they lose, they can impact market functionality by demanding too many trades at once.
Example
The National Bank pays amounts based on a fixed rate of 8%. The City Bank pays a reference rate plus 2%. The term is for three years with payments due every six months. Both companies have a notional capital amount of 1 million dollars.
Period Reference Rate City Bank Pays National Bank Pays
0 4%
1 3% $30,000 $40,000
2 4% $25,000 $40,000
3 5% $30,000 $40,000
4 7% $35,000 $40,000
5 8% $45,000 $40,000
6 $50,000 $40,000
(Source: “Interest Rate Swap,” NYU Stern School of Business, 1999.)
Impact on the US Economy
According to the Bank for International Settlements, there are $524 trillion in loans and bonds involved in swap transactions. This is undoubtedly the largest part of the $640 trillion over-the-counter derivatives market. It is estimated that derivatives trading is worth more than $600 trillion. That is 10 times the total GDP of the entire world. In fact, 92% of the largest 500 companies in the world use it to reduce risks.
For example, a futures contract can commit to delivering 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 they are based on, they are not traded on an exchange. As a result, no one knows how many of them exist or what their impact on the economy is.
Frequently Asked Questions
What derivatives are used for hedging against interest rate swap transactions?
The CME Group offers several futures contracts based on interest rate swaps. These futures include options for swaps indexed to SOFR and LIBOR.
What is the current base interest rate?
The base interest rate refers to the “benchmark rate” or “base rate” that banks use to determine loan costs. It is the lowest possible rate, and banks add other costs to it to account for risk factors related to an individual’s loan application. The Federal Reserve publishes the daily base interest rate for the primary bank along with many other rates on its selected interest rate list.
Source: https://www.thebalancemoney.com/interest-rate-swaps-3306248
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