One of the largest components of the global derivatives markets and a
natural adjunct to the fixed income markets is the interest rate swaps market.
Understanding the over-the-counter swaps market can give you a deeper insight
into the capital flows that drive the bond markets, the way in which the
companies whose stock you own manage their exposure to fluctuations in interest
rates and the way banks and financial institutions make a great deal of their
income.
What is an interest rate swap? Simply put, it is the exchange of one set of
cash flows for another. A pre-set index, notional amount and set of dates of
exchange determine each set of cash flows. The most common type of interest
rate swap is the exchange of fixed rate flows for floating rate flows.
For example, in the United States, you might have a company called Acme Tool
& Die with a relatively poor credit rating that borrows most of its funds
with short maturities. Acme may want to change its exposure to interest rates
to more correctly reflect the long-term nature of the projects it is funding.
Or, Acme may believe that long-term interest rates are going to rise, causing it
to seek protection against the impact of higher interest rates on its balance
sheet.
One solution is for Acme to enter into an interest rate swap. In exchange
for receiving payments tied to the floating rate index Acme uses for borrowing
in the short maturities (with payment dates corresponding to the dates Acme must
reset its short-term borrowing), Acme would pay a fixed rate index, all on the
same notional amount as its total outstanding borrowings. With the swap, the
managers of Acme have closed out the company's exposure to changes in short term
rates and they have taken on an exposure to long term rates that more closely
corresponds to Acme's long term assets.
Differences in the credit quality between entities borrowing money motivate
the interest rate swap market. Specifically, some agents may have a better
borrowing profile in the short maturities than they do in the long maturities.
Other agents (with more creditworthy status) have a comparative advantage
raising money in the longer maturities.
A counter-party's creditworthiness is an assessment of their ability to
repay money lent to them over time. If a company has a good credit rating, they
are more likely to be able to pay back a loan over time than a company with a
poor credit rating. This effect is magnified with time. By making it easier
for less creditworthy agents to borrow in the short term than in the long term,
lenders make sure that they are less exposed to this risk.
Therefore, we would expect that in fixed-floating interest rate swaps, the
entity paying fixed and receiving floating is usually the less creditworthy of
the two counterparties.
The interest rate swap gives the less creditworthy entity a way of borrowing
fixed rate funds for a longer term at a cheaper rate than they could raise such
funds in the capital markets by taking advantage of the entity's relative
advantage in raising funds in the shorter maturity buckets.
As we shall see in a later article, this arbitrage opportunity is expanded
when we consider agents who can borrow money in a number of different
currencies. In that case, we can think of a matrix of currency and maturity to
describe an entity's relative arbitrate opportunities. This can be addressed
using currency swaps.
Of course, fixed-floating interest rate swaps are not the only kinds of
interest rate swaps we can construct. Any kind of interest rate swap is
possible, as long as the two counter-parties can come up with differing indices.
We could imagine a swap in which there are two different kinds of floating
indices or another in which there are two different kinds of fixed indices.
In subsequent articles, we shall also see how swaps can be constructed using
equity indices and commodity indices and the rationale for using these
structures instead of outright purchases of the underlying equities and
commodities.
How do we value swaps? There are several steps:
1. Identify the cash flows. To simplify things, many people draw diagrams
with inflows and outflows of funds over time.
2. Construct the swap curve, obtained from the government yield curve and
the swap spread curve.
3. Construct a zero-coupon curve from the swap curve. (See the Fixed
Income section).
4. Present value the cash flows using the zero-coupon rates.
The swap spread is obtained from market makers. It is the market-determined
additional yield that compensates counter-parties who receive fixed payments in
a swap for the credit risk involved in the swap. The swap spread will differ
with the creditworthiness of the counter-party.
Just like an option, a swap can be at-the-money, in-the-money or
out-of-the-money. Most swaps are priced to be at-the-money at inception meaning
that the value of the floating rate cash flows is exactly the same as the value
of the fixed rate cash flows at the inception of the deal. Naturally, as
interest rates change, the relative value may shift. Receiving the fixed rate
flow will become more valuable than receiving the floating rate flow if interest
rates drop or if credit spreads tighten.
Investment banks and commercial banks are the market makers for most of
these swaps. Most of them warehouse the risk in portfolios, managing the
residual interest rate risk of the cash flows. As you can imagine, the
management of these risks can be very complex with swaps maturing on a daily
basis and the difficulties of managing a variety of similar but not identically
matched products.
A later article will talk about exotic interest rate swaps.
Article by Chand Sooran, Principal Victory
Risk Management Consulting, Inc. |