Swap Markets Explained: Interest Rate and Currency Swaps

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 Series: Chapter 15 Review

A swap is an agreement between two parties to exchange a set of payments over time. The most common type swaps fixed interest rate payments for floating ones. Chapter 15 covers the different types of swaps, how they are priced, what risks they carry, and how the swap market nearly brought down the financial system.

The Basics of Interest Rate Swaps

In the simplest swap, one party pays a fixed interest rate while the other pays a floating rate (usually tied to LIBOR). The payments are calculated on a notional principal amount. Nobody actually exchanges that principal. It is just a number used to calculate the payments.

At each payment date, the two amounts are netted out. If Party A owes $3.3 million (fixed) and Party B owes $3 million (floating), Party A sends the $300,000 difference to Party B. Clean and simple.

Swaps trade over the counter, not on exchanges. Each deal is customized, which means the provisions (notional amount, fixed rate, floating rate index, payment frequency, and duration) are negotiated between the parties. The market became popular in the early 1980s when interest rate volatility made financial institutions realize they needed better tools to manage rate exposure.

Why Institutions Use Swaps

Think about a U.S. savings bank that funds itself with short-term deposits but holds long-term fixed-rate mortgages. If rates rise, its deposit costs go up but its income stays the same. That is a problem.

Now think about a European bank that has long-term fixed-rate deposits but makes floating-rate loans. If rates fall, its loan income drops but its costs stay fixed. Also a problem.

A swap solves both problems at once. The U.S. bank sends fixed payments to the European bank and receives floating payments in return. If rates rise, the U.S. bank’s higher floating income from the swap offsets its rising deposit costs. If rates fall, the European bank’s lower swap payments offset its declining loan income.

The trade-off: each institution gives up the benefit of favorable rate movements. But that is the whole point of hedging. You narrow the range of outcomes.

The reason swaps exist at all is market imperfections. In theory, each bank could just restructure its balance sheet. In practice, U.S. depositors want to keep their money in U.S. banks, and European depositors want to keep theirs in European banks. Swaps let institutions get the risk profile they want without changing how they raise funds.

Types of Interest Rate Swaps

Madura covers eight varieties. Here are the most important ones.

Plain Vanilla Swap

The standard fixed-for-floating swap. The Bank of Orlando pays 9% fixed and receives LIBOR + 1% floating on $100 million notional principal for five years. If LIBOR rises to 10%, the bank receives 11% and pays 9%, netting a $2 million gain that year. If LIBOR drops to 4%, the bank receives 5% and pays 9%, netting a $4 million loss.

Forward Swap

The swap begins at a future date, not immediately. Detroit Bank expects to shift toward more fixed-rate loans in three years. It arranges the swap now to lock in favorable terms. If rates are higher in three years, the fixed rate on a new swap would be higher too. By arranging a forward swap today, Detroit Bank potentially gets a lower fixed rate.

Callable Swap

The fixed-rate payer has the right to terminate the swap early. Useful if you hedge against rising rates but rates end up falling. You stop the swap and enjoy the benefit. The cost is a slightly higher fixed rate than a plain vanilla swap, because the option to terminate has value.

Putable Swap

The floating-rate payer has the right to terminate. Same logic in reverse. If a European bank hedges against falling rates but rates rise instead, it can exit the swap and benefit from the higher rates on its floating-rate loans. The cost is a slightly higher floating rate.

Extendable Swap

The fixed-for-floating party can extend the swap beyond its original term. If rates are still rising at the end of the swap period, you keep the swap going at the original (now favorable) fixed rate rather than negotiating a new swap at higher market rates.

Rate-Capped Swap

The floating payments are capped at a maximum rate. The floating-rate payer limits its worst-case scenario by paying an upfront fee. For the fixed-rate payer, this means the floating payments they receive will stop growing past a certain level, even if rates keep rising. It reduces the effectiveness of the hedge at high rate levels.

Equity Swap

Instead of exchanging interest payments, one party pays a fixed rate and the other pays the rate of appreciation of a stock index (like the S&P 500). If the index goes up 9% and the fixed rate is 7%, the equity payer sends 2% of notional principal. If the index only goes up 4%, the fixed payer sends 3%. This lets portfolio managers boost equity exposure without actually buying stocks.

Risks of Interest Rate Swaps

Basis Risk

The floating rate index in the swap might not move in perfect tandem with the institution’s actual costs. If LIBOR rises 0.7% but a bank’s deposit costs rise 1%, the swap does not fully cover the gap.

Credit Risk

Your counterparty might not pay. If they default, you stop paying too, but you lose the future net payments you were expecting to receive. Financial intermediaries often guarantee swap payments for a fee. This helps, but it also concentrates risk at the intermediary level.

The AIG situation during the 2008 crisis was a textbook example. AIG had guaranteed an enormous amount of swap payments. When it could not honor those guarantees, the potential chain reaction through the global swap network was considered so dangerous that the U.S. government rescued AIG rather than let it fail.

Sovereign Risk

A foreign counterparty might be perfectly creditworthy, but its government could impose exchange controls or nationalize the firm, preventing it from making payments. You cannot assess this risk by looking at the counterparty’s financial statements alone.

Pricing Swaps

Three factors determine the terms of a swap.

Prevailing interest rates set the baseline. When market rates are high, the fixed rate in a swap will be high. When rates are low, fixed rates are low.

Availability of counterparties matters too. If everyone expects rates to rise, lots of institutions want to swap fixed-for-floating, but few want the other side. This scarcity drives up the fixed rate. In periods when expectations are mixed, finding a counterparty is easier and terms are more competitive.

Credit and sovereign risk affect the fixed rate as well. Higher risk counterparties will get a less favorable rate. If a respected intermediary guarantees the swap, both parties feel more secure and terms adjust accordingly.

Interest Rate Caps, Floors, and Collars

These are related instruments that work differently from swaps but serve similar purposes.

An interest rate cap pays you when a reference rate exceeds a ceiling. You pay an upfront fee. If rates rise above the cap, you receive payments that help offset your higher costs. If rates stay below the cap, you get nothing and your fee is lost.

An interest rate floor is the opposite. It pays when rates fall below a specified level. Institutions that earn floating-rate income buy floors to protect against rate declines.

An interest rate collar combines a cap and a floor. You buy a cap (protection against rising rates) and sell a floor (giving up gains if rates fall below a level) to partially offset the cost of the cap.

Using Swaps for Financing Advantages

Swaps can also help companies get better borrowing rates. Quality Company can borrow at 9% fixed or LIBOR + 0.5% floating. Risky Company can borrow at 10.5% fixed or LIBOR + 1% floating. Quality has an advantage in both markets, but a bigger advantage in fixed-rate borrowing.

The solution: Quality borrows fixed at 9% and Risky borrows floating at LIBOR + 1%. Then they swap. Quality pays Risky LIBOR + 0.5% and receives 9.5% fixed. Both sides end up paying less than they would have on their own. Quality saves 0.5% on its effective floating-rate cost. Risky saves 0.5% on its effective fixed-rate cost.

My Take

Swaps are the least intuitive of all the derivatives covered in this book. Futures are bets on price. Options are bets with a safety net. Swaps are ongoing arrangements where two parties trade cash flow streams because each one has something the other wants.

The Orange County story is the standout example. In 1994, the county treasurer bet heavily that interest rates would fall. Instead, rates rose throughout the year. Rather than cutting losses, he doubled down again and again. The county lost over $2 billion and filed for bankruptcy. It is a reminder that derivatives designed for hedging can be used for speculation, and that the damage from misuse can be enormous.

The AIG rescue during the 2008 crisis ties this chapter to the real world in a big way. The fear was not just about AIG itself. It was about the chain of swap obligations that connected AIG to banks and financial institutions around the world. If AIG defaulted on its swap guarantees, the losses would cascade. That interconnection, the systemic risk of the swap market, is probably the most important concept in this chapter.

For individual investors, swaps are mostly irrelevant. You will never negotiate one. But understanding them helps you understand how large institutions manage risk, why interest rate changes ripple through the economy, and why a single company’s failure can threaten the entire financial system.

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