Interest rate swap

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In the field of derivatives, a popular form of swap is the interest rate swap, in which one party exchanges a stream of interest for another party's stream. These were originally created to allow multi-national companies to evade exchange controls. Interest rate swaps are normally 'fixed against floating', but can also be 'floating against floating' rate. A single-currency 'fixed against fixed' rate swap would be theoretically possible, but since the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams. Because one party would be definitely at a disadvantage in such an exchange, that party would decide not to enter into the deal. Hence, there are no single-currency 'fixed versus fixed' swaps in existence. If there is an exchange of interest rate obligation, then it is termed a liability swap. If there is an exchange of interest income, then it is an asset swap.

Interest rate swaps are often used by companies to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a company is able to alter their interest rate exposures and bring them in line with management's appetite for interest rate risk.

Swaps Basic Forms

A Swap is an agreement to exchange a sequence of cash flows over a period of time in the future in same or different currencies. Mainly used for hedging various interest rate exposures, they are very popular and highly liquid instruments. Although there are hundreds of types of swaps, some of the very basic swap types are

Fixed - Float (Same currency) Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to X on a notional N for a tenor T years. For example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a notional USD 1 mil for 3 years. Fixed-Float swaps in same currency are used to convert a fixed/floating rate asset/liability to a floating/fixed rate asset/liability. For example, if a company has a fixed rate USD 10 mio loan at 5.3% paid monthly and a floating rate investment of USD 10 mio that returns USD 1M Libor +25 bps monthly, and wants to lockin the profit as they expect the USD 1M Libor to go down, then they may enter into a Fixed-Floating swap where the company pays floating USD 1M Libor+25 bps and receives 5.5% fixed rate, locking in 20bps profit.


Fixed - Float (Different currency) Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B indexed to X on a notional N at an initial exchange rate of FX for a tenor T years. For example, you pay fixed 5.32% on the USD notional 10 mio quarterly to receive JPY 3M Tibor monthly on a JPY notional 1.2 bio (at an initial exchange rate of USDJPY 120) for 3 years. For Nondeliverable swaps, USD equivalent of JPY interest will be paid/received (as per the Fx rate on the FX fixing date for the interest payment day). Note in this case no initial Exchange of notional takes place unless the Fx fixing date and the swap start date fall in the future. Fixed-Float swaps in different currency are used to convert a fixed/floating rate asset/liability in one currency to a floating/fixed rate asset/liability in a different currency. For example, if a company has a fixed rate USD 10 mio loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 bio that returns JPY 1M Libor +50 bps monthly, and wants to lock in the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up(JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate and the fx exposure.


Float - Float (Same Currency, different index) Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency B indexed to Y on a notional N for a tenor T years. For example, you pay JPY 1M Libor monthly to receive JPY 1M Tibor monthly on a notional JPY 1 bio for 3 years.

In this case, company wants to lockin the cost from the spread widening or narrowing. For example, if a company has a floating rate loan at JPY 1M Libor and the company has an investment that returns JPY 1M Tibor+30 bps and currently the JPY 1M Tibor = JPY 1M Libor +10bps. At the moment, this company has a net profir of 40 bps. If the company thinks JPY 1M tibor is going to come down or JPY 1M Libor is going to increase in the future and wants to insulate from this risk, they can enter into a Float float swap in same currency where they pay JPY TIBOR +10 bps and receive JPY LIBOR+35 bps. with this, they have effectively locked in a 35 bps profit instead of running with a current 40 bps gain and index risk. The 5bps difference comes from the swap cost which includes the market expectations of the future rates in these two indices and the bid/offer spread which is the swap commission for the swap dealer.


Float - Float (Different Currency) Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency A indexed to Y on a notional N at an initial exchange rate of FX for a tenor T years. For example, you pay floating USD 1M Libor on the USD notional 10 mio quarterly to receive JPY 3M Tibor monthly on a JPY notional 1.2 bio (at an initial exchange rate of USDJPY 120) for 4 years.

To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese growth, they need JPY 10 bio. the easiest option for the company is to issue debt in Japan. As the company might be new in the Japanese market with out a well known reputation among the Japanese investors, this can be an expensive option. Added on top of this, the company might not have appropriate Debt Issuance Program in Japan and they might lack sophesticated treasury operation in Japan. To overcone the above problems, it can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it introduces two new risks to the company:

1. FX risk. If this if this USDJPY spot goes up at the maturity of the debt, then when the company converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a loss.

2. USD and JPY interest rate risk. If the JPY rates comes down, the return on the investment in Japan might go down and this introduces a interest rate risk component.

The first exposure in the above can be hedged using long dated FX forward contracts but this introduces a new risk where the implied rate from the FX Spot and the FX Forward is a fixed rate but the JPY investment returns a floating rate. Although there are several alternatives to hedge both the exposures effectively without introducing new risks, the easiest and the most cost effective alternative would be to use a Float-Float swap in different currencies. In this, the company raises USD by issuing USD Debt and swaps it to JPY. It receives USD floating rate(so matching the interest payments on the USD Debt) and pays JPY floating rate matching the returns on the JPY investment.


Fixed - Fixed (Different Currency) Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a term of T years. For example, you pay JPY 1.6% on a JPy notional of 1.2 bio and receive USD 5.36% on the USD equivalent notional of 10 mio at an initial exchange rate of USDJPY 120.

Usage is similar to above but you receive USD fixed rate and pay JPY Fixed rate.

Consider the following illustration in which Party A agrees to pay Party B periodic interest rate payments of LIBOR + 50 bps (0.50 %) in exchange for periodic interest rate payments of 3.00 %. Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. if LIBOR + 50 bps is 1.20 % then Party A receives 1.80 % and Party B pays 1.80 %). The fixed rate (3.00 % in this example) is referred to as the swap rate.

Trading An interest-rate swap is one of the more common forms of over-the-counter derivatives. It is the most widely used derivative in terms of its outstanding notional amount, but it's not standardized enough and doesn't have the properties to easily change hands in a way that will let it be traded through a futures exchange like an option or a futures contract.

Valuation and Pricing

The present value of a plain vanilla (i.e. fixed rate for floating rate) swap can easily be computed using standard methods of determining the present value of the components. The swap requires from one party a series of payments based on variable rates, which are determined at the agreed dates of each payment. At the time the swap is entered into, only the actual payment rates of the fixed leg are known in the future, but forward rates (derived from the yield curve) are used as an approximation. Each variable rate payment is calculated based on the forward rate for each respective payment date. Using these interest rates leads to a series of cash flows. Each cash flow is discounted by the zero-coupon rate for the date of the payment; this is also sourced from the yield curve data available from the market. Zero-coupon rates are used because these rates are for bonds which pay only one cash flow. The interest rate swap is therefore treated like a series of zero-coupon bonds.

This calculation leads to a PV. The fixed rate offered in the swap is the rate which values the fixed rates payments at the same PV as the variable rate payments using today's forward rates. Therefore, at the time the contract is entered into, there is no advantage to either party, and therefore the swap requires no upfront payment. During the life of the swap, the same valuation technique is used, but since, over time, the forward rates change, the PV of the variable-rate part of the swap will deviate from the unchangeable fixed-rate side of the swap. Therefore, the swap will be an asset to one party and a liability to the other. The way these changes in value are reported is the subject of IAS 39 for jurisdictions following IFRS, and FAS 133 for U.S. GAAP.

Credit Risk

Credit Risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party. This is true for all swaps where there is no exchange of principal.

Marking to Market

The current valuation of securities in a portfolio. Debt Security Traders mostly use this in order to visualize their inventory at a certain time.

Swaps are also traded at a fixed rate as apposed to par. so when the par rate is 3% if the payer wants to pay 3.5% i.e 50Bps over a cash payment is made to compensate for this.

Market Size

The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market.

Users

Fannie Mae

Fannie Mae uses interest rate derivatives to, for example, "hedge" its cash flow. The products it uses are pay-fixed swaps, receive-fixed swaps, basis swaps, interest rate cap and swaptions, and forward starting swaps. Its "cash flow hedges" had a notional value of $872 billion at December 31, 2003, while its "fair value hedges" stood at $169 billion (SEC Filings) (2003 10-K page 79). Its "net value" on "a net present value basis, to settle at current market rates all outstanding derivative contracts" was (7,712) million and 8,139 million, which makes a total of 6,633 million when a "purchased options time value" of 8,139 million is added.

What Fannie Mae doesn't want is for example a wide "duration gap" for a long period. If rates turn the opposite way on a duration gap the cash flow from assets and liabilities may not match, resulting in inability to pay the bills on liabilities. It reports the duration gap regularly in its (8-K Regulation FD Disclosure), see earlier 10-K's for charts and more information (Investor Relations: Annual Reports & Proxy Statements). (Dec 1999 - Dec 2002 duration gap) , (2003 gap).

Arbitrage Opportunities

Interest Rate Swaps are very popular due to the arbitrage opportunities they provide. Due to varying levels of creditworthiness in companies, there is often a positive Quality Spread Differential which allows both parties to benefit from an Interest Rate Swap.

The interest rate swap market is closely linked to the Eurodollar futures market which trades at the Chicago Mercantile Exchange.