Thursday, February 24, 2011

Interest Rate Swaps: Post-2008 Crisis

This article appeared in The Edge Malaysia, Jan 30, 2011

Interest Rate Swaps – Post 2008 Crisis

In the previous article we discussed the trading of interest rate swaps as we knew it before the credit crisis of 2008. This article will now examine how issues like uncertainty and liquidity after the 2008 credit crisis introduced ‘basis risk’ into the market. We will also see the emergence of the ‘basis swap’ to hedge this risk and how the interest rate derivative market has changed as a result.

The uncertain environment
European finance is changing. Mounting debt, fear of sovereign defaults, instability of the Euro and contrasting

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