Understanding Interest Rate Swaps

What are Interest Rate Swaps?

Interest rate swaps are relatively common in large financial institutions, but because they are relatively unregulated over-the-counter derivatives that do not trade on public exchanges, they're essentially unknown to the general public. A swap is, exactly as it sounds--an agreement between two institutions to exchange future cash flows. For example, a bank receiving a fixed 3 percent return on 2-year money it has lent out (the receiver) might swap this revenue stream against another firm's variable rate 2-year money (the payer). In some swaps it's not the interest rate that varies between the two parties, but the currency. So instead, the arrangement can be a swap of fixed-rate 2-year U.S. dollars for the same rate on 2-year euros. In practice, though, swaps tend to be even more complicated and can involve simultaneous variations of interest rate and currency, as well as other variables. The swap rate, the fixed rate in a swap transaction, is closely linked to the prevailing interest rate on U.S. dollars deposited in non-U.S. institutions.When swaps are settled, the only amount exchanged is the differential between the would-be payments from both parties, never the principal.

Why Swaps?

In the first example above, if interest rates go up over the 2 years, the institution swapping a fixed rate for a variable rate (the receiver) will realize a greater return on its money. The payer in the swap was clearly hedging against rates going down, seeking to lock in what it thought would be a higher fixed rate. This ability to hedge against changes in interest rates is one of the primary uses of interest rate swaps. The other major purpose, as described in the second example, is to hedge against currency risk. Firms with huge lending operations can use such transactions to alter their exposure to interest rate and currency fluctuations. Because they involve very little upfront cost, interest rate swaps are also traded by speculators in these markets.

Trading Swaps

There are generally three basic steps to trading with swaps. First is a choice of maturity date. Traders call this picking a point along the yield curve, referring to the tendency for interest rates to vary depending on the maturity. The second step is to determine what vehicle is being hedged and, third, which direction. Clearly, a party hedging against an increase in interest rates will make a different trade than one expecting lower rates, and these will both differ from a party concerned over too much exposure to a certain currency. Once these basic decisions have been made, determining the dollar value of the swap and the most efficient in money market and futures contracts are fairly advanced concepts and complex mathematics.

Resources

• What Does Interest Rate Swap Mean?
• What Are Interest Rate Swaps and How Do They Work?
• Basic Fixed Income Derivative Hedging