Thursday, February 24, 2011

Interest Rate Swaps: Pre-2008 Crisis

This article appeared in The Edge Malaysia, Jan 17, 2011

The interest rate derivatives market is the largest derivatives market in the world, and among the oldest. Interestingly, the credit crisis of 2008 has turned out to be one of the key watershed moments for this highly established market. The swap market has undergone an evolution – a change in the motivation of trading which brought about new risk that was considered negligible before the crisis.

This article will first brief the reader on the plain vanilla interest rate swap and its prime trading motivations before the crisis.

What is an Interest Rate Swap (IRS)
An interest rate swap is an agreement between two parties to swap interest payments on an agreed notional sum of the same currency.  In the case of a plain vanilla IRS, parties exchange fixed interest rates with floating interest rates.

The interest rate swap is an important tool in hedging for banks and corporations. They can also be attractive speculation instruments as we will see later.

Hedging with the IRS – The example of the commercial bank
Commercial banks that are funded on time deposits (paying fixed rates) and issue floating rate mortgages are exposed to interest rate risk. For instance, say Bank A pays 5% on its time deposits and receives 3-month LIBOR (London Interbank Offer Rate) + 0.2% on its mortgages. Say the LIBOR at the first 3-month interval is 5%. The bank makes a margin of 0.2% from its lending business. Say after 3 months, LIBOR falls to 4.8%. The bank’s margins are now being squeezed.
Bank A would be interested in entering into a fixed-for floating IRS (see Chart 1) where it could swap the fixed interest paid on its time deposits with a 3-month LIBOR. In this way, Bank A is not exposed to the changes in LIBOR as the interest rate risk is hedged with the IRS. The IRS will slightly reduce the bank’s overall margin but worthy in eliminating the bigger downside when LIBOR moves the other way.

Chart 1 – Interest Rate Swap (Hedging example 1)

Hedging with the IRS – The example of the corporation
Say Company B issued a 10 year fixed bond at 8% and it is into its 5th year now. Interest rates have fallen and the company wished it issued a floating rate bond instead. It is not too late. It can enter into an IRS as in Chart 2. Company B pays the floating LIBOR and receives a fixed rate of 6% from the swap counterparty. The net effect of the cash flows of the bond and the IRS to Company B would be: [- LIBOR +6% - 8% = - LIBOR – 2%] So, synthetically the company has managed to pay on its bond, LIBOR + 2% and can now benefit from further falls in the interest rate. The rate may still seem high compared to newly issued bonds, but considering the issuing cost of bonds, the swap transaction does seem worthwhile.
Chart 2 – Interest Rate Swap (Hedging example 2)

 Source: Cusatis, Thomas: Hedging Instruments and Risk Management
Interest rate swaps are also very often used by market participants who want to take a view and profit from the movement in interest rates. The main speculators in the swap market are proprietary trading desk of investment banks and hedge funds.
Traditionally, an investor who expected interest rates to fall would purchase cash bonds, whose price will increase as the interest rates fall. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as interest rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.
A speculator can also take a view of the shape of the interest rate curve, an example of which is Chart 3. The speculator may believe that the difference between the six-month LIBOR rates will fall further relative to the three-year swap rate. The LIBOR only has maturities of up to 12 months. He enters into a constant maturity swap paying the six- month LIBOR rate and receiving the three-year swap rate (which is periodically set to the market swap rate).

Chart 3 – An example of an Interest Rate (Yield) Curve

The IRS market
The interest rate swap market flourishes not only for the reasons of hedging and speculation but also because of two more important features:

§   Quality Spread Differential between firms
Due to the varying levels of counterparty risk of companies, there is often a ‘quality spread differential’ which allows both parties to benefit from an interest rate swap. Say Bank A rated AAA is able to borrow funds at LIBOR + 2% whilst Bank B rated BBB will have to borrow at LIBOR +3%. They could enter into an IRS where Bank B pays LIBOR + 2.5% and receives a fixed rate from Bank A. This is beneficial for Bank B as it is cheaper than financing from the market. As for Bank A, the fixed rate negotiated is often also better than borrowing in the market.

§  Arbitrage Opportunities
The IRS market is closely linked to the interest rate futures and forwards markets. Arbitrageurs continuously trade between forward, futures and swaps resulting in the rates for the different derivatives within the same tenor to stay in close proximity.

Some important features of the IRS
Before we go further, it will be useful to understand some important features of the IRS, such as:

§   Reset dates
These are pre-set dates when the floating rate in the IRS will be reset to the current rate. For example, an IRS that has one floating leg paying 3-month LIBOR (say 5%) will be re-set every three months at pre-determined dates. At these dates, the 3-month LIBOR (which was 5%) will be changed to the current rate (say 4.8%).
§   Fixed Rate or Swap Rate
In a previous article, [Financial Wizardry in Swaps – the Greek case, Mar 8-14, 2010], the swap rate for a cross currency swap was discussed. In any fixed-for-floating swap, the fixed rate to be paid by the Fix Rate Payer will be such that makes the swap ‘fair’. In other words, at the inception of the swap, the price of the swap should ideally be zero. Now, the price of the swap is simply the present value of its floating and fixed cash flows. To make the price zero, the fixed rate is adjusted such to make the present value to be zero. This fixed rate is also known as the swap rate or the at-market swap rate.

New Developments
Now that we have a reasonable level of understanding of the plain vanilla interest rate swap, in the next article, we will study how the swap market changed after the 2008 crisis, bringing about “basis risk” which was considered insignificant before but cannot afford to be sidelined now.

1 comment:

  1. Interest rate swaps is a nice tool you can use to match up your liability responsibilities with the income from your assets. You can also leverage the advantages presented by these agreements to improve your business.