Interest Rate Swaps

Interest rates are unpredictable, especially over the long run. Issuers of bonds could issue short-term bonds to minimize the interest rate risk, but issuing bonds costs money, and the prices, and therefore their yields, will often depend on the bond market when they are sold. Hence, issuers of bonds generally want to issue long-term bonds; so does the United States government. Banks also are subject to interest rate risk when they make long-term fixed rate loans, such as mortgages or business loans. Interest rate swaps allow institutions to synthetically match the duration of their assets with their liabilities.

An interest rate swap can help protect the issuer of bonds, Treasuries, or loans against interest rate risk by transferring the risk to another party in exchange for a variable payment. An interest rate swap, in its simplest form, is a private agreement between 2 counterparties to exchange a fixed interest obligation for a floating rate obligation over a period of time. The payment is calculated by multiplying the interest rate times a notional principal (aka notational principal), which is not exchanged, but is simply a number used to calculate both interest payments. The counterparty paying the fixed amount is the fixed-rate payer and the counterparty paying the floating rate is the floating rate payer. However, only the net difference between these obligations is paid, and who pays whom depends on whom the change in interest rates favors. For instance, if the float rate rises above the fixed rate, then the floating rate payer pays the fixed-rate payer the difference between the floating rate and the fixed rate, but if the floating rate falls below the fixed rate, then the fixed-rate payer pays the floating rate payer the difference in interest rates. It is possible for 1 counterparty to receive all of the payments without paying anything, or it could go back and forth, depending on how interest rates fluctuate.

The fixed rate is usually determined by a benchmark such as a Treasury with a maturity equal to the time period of the swap plus an additional risk premium, which equals the swap rate. The size of the swap rate is called the swap spread, which is sometimes used as an indicator of the systemic risk in the economy.

The floating rate is usually determined by the London Interbank Offered Rate (LIBOR), which is the rate that large banks lend to each other, plus an additional risk premium.

Although there are other types of swaps, such as currency swaps and equity swaps, interest rate swaps are far more prevalent. According to the Bank for International Settlements, the notional principal for interest rate swaps was almost 347 trillion dollars (USD) in June, 2007, while the total for equity-linked and commodity derivatives was 9.2 trillion dollars for the same time period. Because swaps are private agreements, there is no organized exchange that lists them, and because they are tailored specifically for the counterparties, they are difficult to resell.

Swap Credit Risks

When a swap agreement is reached, the present value of both sides is zero, because no money changes hands at first. This must be so, because no one would agree to an arrangement where one party must immediately pay the other. How does that transfer risk? So, if one party withdraws from the agreement before any liability is incurred, there is no loss, for another counterparty can usually be found. Only when interest rates change will there be a payment obligation. However, it is only the difference between the liabilities that is actually paid, which is considerably less than what would be suggested by the notional principal.

For example, consider an interest rate swap for a 5-year period with a fixed payment of 5% on the notional principal of $1,000,000 and the LIBOR rate, which was also at 5% when the contract was created. If the LIBOR rate rises to 6% during the swap period and stays there, then the floating rate payer only has to pay the 1% difference or $10,000 for each of the 5 years. However, the present value of those payments is less than their sum. Hence, the credit risk is significantly less than if the principal were at stake.

Interest Rate Options

Swaptions

A swaption is an option for a swap at a specified rate before a specified time, the expiration date. The buyer of the swaption has the right, but not the obligation, to enter a swap and the swaption seller is obliged to be the counterparty. Swaptions can be American or European style. American style swaptions give the holder the right to enter a swap at any time before the expiration date, while the European style gives the holder the right for only a brief time right before expiration.

A payer swaption (aka put swaption) gives the buyer the right, but not the obligation, to pay a fixed rate and receive a floating rate. The buyer pays the premium to the seller for this right, which, like all options, may expire worthless. A receiver swaption (aka call swaption) gives the option holder the right to receive a fixed interest rate and pay a floating rate based on a specified benchmark.

Interest Rate Caps, Floors, and Collars

There are also options that allow the option holder to receive payment if a specified interest rate known as the reference rate (usually the LIBOR) goes above or below specified limit rates. An interest rate cap allows the holder to receive a payment from the seller equal to:

(Reference Rate – Limit Rate) x Notional Principal, if positive.

Obviously, no payment is made if the reference rate is less than the limit rate.

Similarly, an interest rate floor pays the holder an amount equal to:

(Limit Rate – Reference Rate) x Notional Principal, if positive.

An interest rate collar combines the interest rate cap and floor by paying the option holder the difference if the reference rate is above the upper limit rate or below the lower limit rate.