Course Overview:

Interest rate swaps are used by a wide range of market participants worldwide as a method of changing interest rate exposure from fixed to floating and vice versa, or from one floating rate to another. The market has grown substantially since its creation in the early 1980s. The most important feature of swaps for borrowers is that they enable borrowers to access the market that offers the lowest cost of funds without having to tailor the funding to a particular maturity, rate preference, payment frequency, or currency. Borrowers and investors can also use swaps to restructure their balance sheets or to take speculative positions on the direction of interest rates.

Intermediate

30 minutes

01/30/2020

Derivatives, Foreign Exchange & Risk Management

Learning Objective:

• Describe the interest rate swap market in terms of market structure and participants.

Introduction

Interest rate swaps are used by a wide range of market participants worldwide as a method of changing interest rate exposure from fixed to floating and vice versa, or from one floating rate to another. The market has grown exponentially since its creation in the early 1980s. In this unit, swap market terminology is defined, swap market participants are outlined and the creation and growth of the swap market is reviewed. In addition, the uses and benefits of swaps are outlined and analyzed in general and by working through a hypothetical swap transaction.

Terminology

An interest rate swap is an agreement between two parties to exchange a set of cash flows over a specific period of time. These cash flows are based on underlying interest rates in the same currency. A swap allows users to alter the nature of interest payments on liabilities or income from assets in several ways.

• The interest rate basis can be converted from fixed to floating, floating to fixed or even from one floating-rate index to another. The most common type of swap is called a coupon swap. It is the exchange of a fixed-rate coupon for a floating-rate coupon.
• The repricing interval, that is, the period between resettings of the periodic interest rate, can be altered.
• Swaps can be used to take a position on the direction and magnitude of future interest rate movements.

The interest rate swap market has ballooned since its creation in the early 1980s. Not only has the volume of transactions increased, but also the types, users and currencies in which they are available have multiplied. The payments exchanged in an interest rate swap are determined by two factors: the notional principal amount and the interest rate, whether fixed or floating. Floating rates are typically based on some published index of market rates. The following terms are important:

• Notional Amount.The underlying principal amount upon which swap payments are calculated. The notional principal of an interest rate swap is not exchanged; only the interest rate payments are.
• Swap Rate. Usually the fixed rate in a swap contract. It is normally quoted in percentage terms and stipulated in the written confirmation of the swap transaction. The payment frequency and dates affect the effective cost of the transaction and must be specified in the written confirmation.
• An interest rate swap is simply a series of FRAs, instead of each FRA having its own fixed rate an IR Swap sets one average rate for the entire set of cash flows. The second difference Is that payments are made at the end of each period (called in arrears), not at the beginning. Thus there is no need to discount the netted cash flow payments.
• Floating-Rate Index. The basis on which the floating-rate payment is determined.


• Common floating-rate references include LIBOR, certificates of deposit (CDs), commercial paper (CP) and bank bills.
• The floating rate can be reset every month, quarter, etc. For example, six-month LIBOR can be reset monthly.
• The frequency and dates of payment can be different from the reset dates. For example, a LIBOR rate might be reset monthly with payment exchanges made every six months. Most rates are set in advance, but some may be determined in arrears.
• Tenor. The designated maturity of the swap.

Market Participants

Participants in a swap transaction include the following:

• Counterparty. Any institution, business or individual that has entered into a swap transaction.
• Fixed-Rate Payer. The counterparty that is obligated to make payments based on a fixed rate and receive floating-rate payments.
• Floating-Rate Payer. The counterparty that will receive fixed-rate payments and make floating-rate payments.

Swap participants can be classified in two categories:

• End users. A counterparty that is not a professional intermediary in swaps. End users engage in swaps to alter the risk exposure of their assets or liabilities or to take a position on future rate movements. They are either the fixed-rate payer or the floating-rate payer, according to their position in the swap.
• Intermediary or Market Maker. An institution that enters into offsetting transactions with end users and assumes the rights, obligations and risks of both counterparties. Intermediaries earn spreads from buying and selling swaps.

As the market has expanded and changed, so has the range of institutions taking the role of intermediary. In the early days of the US swap market, investment banks were the main intermediaries, often brokering transactions without becoming a legal party to the agreement.

Commercial banks first became intermediaries by simply taking the credit risk and performing the operational functions. Investment banks would structure transactions and then essentially pay a small portion of the structuring fee to a commercial bank to act as intermediary. As the market became more active and liquid, the willingness of commercial banks to be a party to the deal provided them with an advantage over investment banks. Commercial banks have since taken a larger role in structuring swaps and are a driving force in the swap market.

In the 90s credit concerns in the interbank market caused some interesting shifts in the industry. Pioneers in the swap industry found that their credit capacity was fully utilized as a result of both declining creditworthiness and the fact that they had been in the business the longest and had done large volumes in the interbank market.

A significant portion of swap business next shifted to large, highly rated banks that are well capitalized, including many European institutions. Another participant has been insurance companies (or their subsidiaries), which are well capitalized and good at assessing risk. In addition, many institutions of all types (investment banks, insurance companies and commercial/universal banks) have established separate subsidiaries with their own capital to engage in the swap business.

By 2000, almost all financial institutions had moved to a new credit model for dealing with the potential risks of default. All swap dealers operate under an International Swaps Dealers Agreement (ISDA), in addition financial institutions also executed Collateralized Swap Agreements (CSAs). The CSA obligates the two parties to exchange the market value of the swap on a monthly, weekly (or most often) daily basis. This works in a similar fashion to the margin account in futures trading. Were financial institution to fail, the exposure to their interest rate swaps would be covered and the chances of loss greatly minimized.

In 2008, this was put to the ultimate test with the bankruptcy of Lehman Brothers, because of the collateral swap agreements under which Lehman operated, a systematic collapse was avoided. In the wake of this crisis, the Dodd-Frank legislation has set up a clearing system for OTC transactions, legally obligating financial institutions to collateralize their transactions.

Historical and Market Perspective

The interest rate swap market has existed for a relatively short time compared to other financial products. Though forms of swaps existed in the mid- to late 1970s, the first swap considered significant in terms of size and structure did not occur until August of 1981. This was not an interest rate swap but a currency swap involving IBM and the World Bank, two organizations that have continued to be quite active in the swap market.

Interest rate and foreign exchange rate volatility were the original motivations for the creation of swaps. In the US, the high inflation era of the late 70s created a period of sustained high and volatile interest rates. This provoked the initial growth of interest rate swaps in US dollars. Similarly, the Bundesbank's decision in 1988 to push German interest rates up to levels unseen in Germany for several years sparked tremendous growth in Deutschemark-denominated interest rate swaps.

As corporate treasurers have become more aware of the risks they face in interest rate and currency movements and have become more sophisticated and aggressive in dealing with this exposure, interest rate swap markets have grown significantly. As of 2009, the BIS estimates the notional amount of outstanding interest rate swaps was USD 342 trillion worldwide.

There are a number of facts worth noting about the global market for interest rate swaps:

• Transactions as large as USD 1 billion are possible in highly liquid markets like the US dollar.
• A most common transaction size is US 100 million although the notional amounts for many transactions are considerably higher. The average size varies considerably among markets, based on their liquidity.
• In most swap transactions, the floating rate is based on LIBOR in the appropriate currency. Notable exceptions to this are the Canadian dollar market (where the bankers' acceptance rate is the common reference) and Australian dollar market (where the bank accepted bill rate is used).
• It is estimated that 65% of swap volume is in maturities of three years or less, though maturities of ten and thirty years are frequent in developed markets.

Uses and Benefits

The growth in the use of interest rate swaps is due primarily to their ability to meet the needs of many types of end users in almost all market environments. From the standpoint of end users, swaps can be used to accomplish several goals:

• assist in obtaining the lowest-cost source of financing for borrowers
• help obtain the most attractive investment yield for investors
• restructure the interest rate sensitivity of the balance sheet (assets or liabilities) to take advantage of expected changes in interest rates
• take an open position on the future direction of interest rate movements, without committing large amounts of capital

Before swaps existed, companies chose financing instruments based on factors such as maturity (long-term vs. short-term), interest rate sensitivity (fixed vs. floating rates), payment frequency (monthly, quarterly, semiannually, etc.) and currency (local vs. foreign). The instrument that a company chose had to meet its requirements in each of these areas. With interest rate swaps, however, each of these issues can be addressed separately and independently from the initial financing decision. In essence, swaps allow the structure of the underlying borrowing/investment instrument to be separated from the question of interest rate risk sensitivity. Prior to the swap market, the interest rate risk position was tied to the structure of the underlying instrument.

Raising Lowest Cost Funds

Swaps allow users much greater flexibility in accessing various sources of financing. For example, perhaps a company wants to issue bonds. If interest rates are low, the market may be willing to pay a lower spread for floating rate notes then fixed rate notes. The company can issue the floating rate debt at the lower spread and then execute a swap to fix a long term rate at a lower overall cost of funding. This kind of swap is called a “Floating to Fixed Interest Rate Swap”.

Floating-to-Fixed Interest Rate Swap

This transaction is typical of many swaps, which often have the following characteristics:

• Bank A, typically an AAA-rated European bank, has LIBOR-based assets.
• Bank A has traditionally funded in the floating-rate market and, therefore, has few fixed-rate securities available on the market.
• Investors want to buy fixed-rate securities, and are willing to accept a yield below that of comparable securities, in order to diversify their portfolios.
• Company B is a medium-quality corporation that is able to borrow most cheaply in the floating-rate market.

Through a swap transaction, the bank is able to:

• issue in the fixed-rate market
• swap into a floating rate, matching the rate sensitivity of its assets
• achieve a total cost below its normal funding rate

Company B is able to obtain fixed-rate funds at a rate below the cost of issuing directly into the fixed-rate market.

Restructuring the Balance Sheet

After a year or so, the treasurer of this same Company in the previous example decides that rates will soon fall and the company would be better off with floating-rate debt. The company could then reverse the first swap by doing a second fixed-to-floating interest rate swap. This is illustrated by the diagram titled "Fixed-to-Floating Interest Rate Swap."

Fixed-to-Floating Interest Rate Swap

The first swap, in which the company pays fixed to Bank A (sometimes referred to as a primary market or new issue-driven swap), was driven by the fact that the company could access cheaper funding, but with a structure it felt was inappropriate for managing long term funding costs. The swap made it possible for the company to achieve both its objectives of obtaining the cheapest funding and managing their long term interest rate exposure.

The second swap, in which the company restructures its balance sheet (occasionally referred to as a secondary market swap), was driven more by expectations of rate movements. Over the life of a specific asset or liability changes in interest rate expectations can lead to several swaps whose purpose is to convert the end-user's interest rate sensitivity back and forth between floating and fixed rates.

Capitalizing on Opportunity (Speculation)

Some sophisticated and aggressive users take positions with swaps solely because they have certain expectations of future rate movements or other events.

• Swaps can be used to act on expectations of either rising or falling interest rates. An investor who expects rising rates will transform a fixed-rate asset into a floating-rate asset by using an interest rate swap.
• Swaps can be actively traded like any other commodity.

Summary

• An interest rate swap is an agreement between two parties to exchange a set of cash flows over a specific period of time. The cash flows are based on interest rates that must be in the same currency.
• Interest rate swaps can be used to alter the underlying rate basis from floating to fixed, fixed to floating or even from one floating rate to another.
• The parties in a swap are either end users or intermediaries, and they are either fixed-rate payers or floating-rate payers.
• The most important feature of swaps for borrowers is that they enable borrowers to access the market that offers the lowest cost of funds without having to tailor the funding to a particular maturity, rate preference, payment frequency or currency.
• Borrowers and investors can also use swaps to restructure their balance sheets or to take speculative positions on the direction of interest rates.

Key Terms

Exercises

These exercises are intended only to test your retention of the materials presented in this Learning Unit, and are not part of the overall Competency Test. The results of this Self Test are not recorded.