Interest Rate Exposures
When it comes to interest rates, when rates are rising, people with floating rate mortgages will wish that they had a fixed-rate mortgage instead to shield them from interest increases. On the flip side, bond investors would of course prefer to own floating rate securities in a rising interest rate environment as opposed to earning a fixed rate.
Unfortunately, consumers and individual investors don't usually have much options to flip (or swap) between fixed-rate interest arrangements and floating-rate arrangements.
Global markets, however, allow banks and large corporations to modify their interest rate exposures through the use of what trading desks call swaps. In fact, large organizations can also alter their currency exposures, and other types of exposures using swaps.
By engaging in a swap, two different parties, usually large institutions can effectively trade different financial exposures - not entirely different than two sports teams trading players who have different attributes.
What Is An Interest Rate Swap?
An interest rate swap is an exchange of cash flows between two parties, with the agreement linked to interest rates. Swaps are considered derivatives, similar to options and other securities who derive their value from the value of other securities.
An interest rate swap is arranged for a set period of time and a set amount of principal (called the "notional value"). An intermediary, such as a brokerage trade desk, handles the exchange of cash flows at regular intervals (say monthly or quarterly) and holds collateral from both parties throughout the duration of the agreement to ensure that all terms of the contract are adhered to. Ownership of securities or other collateral does not change hands, so there is no sale or purchase associated with an interest rate swap. The parties engaged in the swap are simply trading cash flows.
Swaps are executed as unique contractual agreements between two parties. They are thus transacted in an over-the-counter fashion with intermediaries connecting the two parties involved. There is no formal market or exchange for swaps, though large banks will quote prices for commonly sought-after swap parameters.
Because there are so many swaps implemented around the world, an international body called the International Swaps and Derivatives Association (ISDA) was set up to establish a common set of rules by which swaps are governed. As such, and because swaps are highly collateralized on both sides of the transaction, interest rate swaps are well-established on a global basis and considered very low risk from a counterparty perspective (economic losses can of course occur).
The intermediaries get fees for handling the swaps, which makes it worth doing on an ongoing basis, and since trust is important in swaps, the intermediaries tend to be prominent multinational banks.
Note: Swaps are often seen as an extension of a forward contract. A forward contract is an agreement to exchange a commodity for cash on a certain date in the future. A swap is an agreement to exchange cash for cash on regular recurring dates for a set period into the future. For this reason, swaps can be calculated as a series of forward contracts for cash at various expected interest rates.
What Is A Fixed Rate?
A fixed rate is an interest rate that is predetermined and locked-in. The rate does not change. So if a party has secured a loan at a rate of 7%, they will pay 7% interest for the duration of the loan term. Corporate and government bonds with stated coupon rates are fixed at an annual rate for their duration. Their market value can change, but their interest payment stream to holders remains fixed.
What Is A Floating Rate?
A floating rate is an interest rate that can vary over time. A floating rate is based on a short-term reference rate, plus or minus a specified amount. Since short-term interest rates vary, the overall rate for the swap varies also, resulting in an interest rate that essentially 'floats' over time with changes to the reference rate.
So if a party secured a floating rate loan at, say, prime + 2.5%, and if the prime rate increases by 1%, the interest costs on that loan will also increase by 1% of the loan value. In this example, if the prime rate was originally 5%, it would mean that the borrower was originally paying 7.5% interest (5% + 2.5%), but thereafter that rate increased to 8.5% (6% + 2.5%).
Note: Most lines of credit carry a floating rate of interest. This is true for both individuals and companies.
Institutions will commonly use a reference rate called the Secured Overnight Financing Rate (SOFR), which replaced the old London Interbank Operating Rate (LIBOR) following the revelation that LIBOR was being manipulated.
How Do Interest Rate Swaps Work?
The exchange of cash flows is based on an agreed amount of notional for a specified time period. The notional amount (say $100 million) applies to both parties, who post collateral to ensure their responsibility in the swap.
Swaps are established at equivalent, or at least perceived-to-be equivalent, economic value. For instance, a party paying a fixed 6% rate on a loan is unlikely to swap those payments for a floating rate of SOFR + 4% if the SOFR rate currently stands at 5%, because that would mean immediately paying 9% interest instead of the original 6%! It wouldn't be a fair transaction! If that deal were offered, the party seeking to swap their 6% fixed loan rate would simply decline and find a better offer from another counterparty.
Important: It's not imperative that economically fair swaps be struck at currently equivalent rates. For example, if a 6% fixed rate payer believes that interest rates will drop, they might be happy swapping their fixed 6% rate for SOFR +1.25% when SOFR stands at 5%. Even though that translates to paying a 6.25% interest rate instead of the original 6% in the immediate term, if SOFR drops by 0.5%, suddenly they'd be paying less than 6%. This is one reason why interest rate expectations are religiously investigated by markets.
Interest Rate Swaps are set up as formal agreements between two parties that are generally handled by an intermediary who ensures that all terms are met and collateral is posted. Intermediaries follow ISDA rules and protocols, as do the parties involved.
Payments between counterparties to a swap are usually netted. If party "A" owes party "B" $10 million, and "B" owes "A" $9 million, typically party "A" will pay the net amount of $1 million.
Who Uses Interest Rate Swaps?
Large financial institutions and corporations use Interest Rate Swaps to help manage their cash flows and interest rate exposure. Swaps represent a global practice and generally involve entities who conduct international business.
The demand for swaps emanates from the following characteristics of international organizations:
- They need to manage large and complex cash flows
- They may be exposed to the risk of interest rate rises or declines
- They deal in different currencies and interest rates in different countries
- They may be able to raise capital at different interest rates around the world
- Their tax rates differ in different countries
If a large corporation receives monthly revenues that are directly sensitive to interest rates (i.e. - floating), but has liabilities that are fixed rate, it might seek to alter its liability structure to floating rates also to lock in a spread. The current conversion parameters for fixed to floating and the company's view of whether interest rates will rise or decline, will determine whether they find a floating rate over a fixed rate for the specified time period to be attractive.
Types Of Swaps
In addition to Fixed-For-Floating interest rate swaps (also called an Overnight Indexing Swap), there are others:
Basis swaps - an exchange of two floating rates using different bases (reference rates)
Currency swaps - an exchange of both principal and interest payments in one currency for another
Fixed-for-fixed interest rate currency swaps - an exchange of fixed rate cash flows in different currencies
Inflation swaps - an exchange of fixed rate cash flows based on different inflation expectations
Credit default swaps - where one entity will pay the other in the case of a specified credit event. Credit default swaps were a popular financial product during the financial crisis of 2008-2009
Commodity swaps - an exchange of a floating price for a fixed price on a specified commodity (usually oil)
Equity swaps - an exchange of cash flows from different securities or indexes
Interest Rate Swap Example
An example of a simple Interest Rate Swap would be as follows:
Apple (AAPL) wants to receive 3-month SOFR plus 1%; and pay a fixed rate of 3% per annum to Citigroup (C) every 3 months for 2 years on a notional principal of $100 million.
A diagram of the swap is shown below.
If SOFR currently stands at 2%, the floating rate of SOFR + 1% will be equal to the returning fixed rate of 3%. At the notional of $100 million, it would mean that each party owes each other $3 million for the year, for a net of zero.
If, however, SOFR stood at 2.5%, Citigroup would owe 3.5% (2.5% + 1%) to Apple, or $3.5 million, while Apple would owe Citigroup $3.0 million. Netted out, Citigroup would pay Apple $500,000.
Bottom Line
Large institutions and international corporations use swaps of various kinds to help manage their cash flows, tax liabilities, capital raising effectiveness, and interest rate risk exposure. While swaps are not typically available to individuals, they may appear on the balance sheet of a public company and may thus inform investors about the cash flows and rate risks of those companies.
