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Interest Rate Swap: Curves and Cash Flows

An interest rate swap gives companies a way of managing their exposure to changes in interest rates. They also offer a way of securing lower interest rates.

Examining An Interest Rate Swaps

One of the largest components of the global derivatives markets and a natural supplement to the fixed income markets is the interest rate swap market.

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, 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 correspond to Acme’s long-term assets.

Differences in the credit quality between entities borrowing money motivates 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 interest and receiving floating interest is usually the less creditworthy of the two counterparties.

An interest rate swap gives the less creditworthy entity a means of borrowing fixed rate funds for a longer term, and at a cheaper rate, than they could raise such funds in the capital markets. This is done by taking advantage of the entity’s relative advantage in raising funds in the shorter maturity buckets.

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.

How Do We Value Swaps?

There are several steps involved in valuing an interest rate swap:

1. Identify the cash flows

To simplify things, many people draw diagrams with inflows and outflows representing 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

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 and Commercial Banks

Investment banks and commercial banks are the market makers for this type of interest rate swap. 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.

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