Interest Rate Swaps II

Interest Rate Swaps - What they are

When two parties agree to enter an interest rate swap (IRS) one party pays a fixed rate of interest and the other a variable rate. The variable rate is often referenced to Libor or Euribor. The interest payments are based on a notional amount, (with IRS no principal amount changes hands). In the market there are conventions for calculating the interest payments. For example USD IRS use an annual actual 360 interest rate calculation for the fixed payment and a quarterly or semi annual actual 360 calculation for the floating payment.

Maturities are normally between 2 and 20 years but it is possible to trade swaps that have maturities exceeding 50 years. Customers using swaps to hedge can expect a dealer to quote a dealing spread. The dealer will want to receive a higher fixed rate than the one they pay. It’s one way the dealer makes money from trading.

Dealers will insist before trading that the appropriate documentation is signed. For swaps standard documentation  is provided by the International Swaps and Derivatives Association (ISDA). This document is called a master agreement. It covers all swaps between the two parties. Individual transactions are then agreed by confirmation which refers to the master agreement.

Variations

The notional amount of an IRS is normally constant throughout its life. But there are variations. An amortising swap is where the notional amount reduces over the life of the deal. An accreting swap is one where it increases. Amortising swaps are often associated with hedging loans that have principal repayments. Amortising swaps are sometimes associated with hedging interest payments on cash deposits.

A further variation can occur with swaps that are agreed today but where the interest payments start accruing from a forward date. These are known as forward starting swaps. They are associated with the hedging of assets and liabilities that have forward drawdown dates.

Dealing prices for these more structured swaps are less transparent and bank customers should always be in a position to compare quotes in order that they receive fair value.

Using swaps  

Swaps are predominantly used by bank customers to hedge interest rate risk. Dealers use them for both hedging and speculation.

A company borrowing on a floating rate basis may be concerned about the potential for a rise in interest rates. Under such circumstances the Treasurer can use the swap market to hedge. The corporate pays fixed interest and receives Libor. This converts the floating rate liability to fixed rate liability. The net fixed rate cost of funds will depend on the current swap rate and any existing borrowing margin on the funding.

If interest rates subsequently rise the company will have a fixed rate cost of funding that is lower than the market rate. But if rates fall the company will have a fixed interest cost of funding that is higher than the current market rate.

Should the company wish to repay the loan early the swap should be cancelled. Failure to do so will leave the company open to changes in the value of the swap without a corresponding position. Cancellation of the swap may not be straight forward, (see later).

Swaps can be used by dealers to speculate on the movement of interest rates, the shape of the yield curve or the differential between bond market yields and swap yields. Here is a simple example.

A dealer anticipates interest rates to rise. How can this dealer speculate using swaps? The dealer enters a swap to pay a fixed rate of interest and receive floating. If interest rates subsequently increase this dealer gains. The swap he entered allows him to pay a fixed rate beneath the market rate. The swap will have a positive market value.

IRS valuations

Why would you want to value a swap? There are a number of reasons. The swap could be in a trading portfolio. Trading portfolios are marked-to-market. Alternatively the swap could be in a hedge portfolio and you are testing hedge effectiveness. You may just want to cancel the trade. What ever the reason dealers use trading systems and/or spread sheets to value swaps.

The principle is straight forward. The fixed interest amounts are calculated from the agreed fixed rate on the trade. The floating payments are normally determined by reference to the forward rates.

In order to value a swap all the fixed and floating interest payments are discounted to provide the deal’s net present value. When this value is negative you are losing money on the trade. When it is positive you are gaining.

You may anticipate that both parties to an IRS would have identical valuations. This is simply not the case. This is more noticeable when customers try to cancel swaps. The value quoted by the dealer can be significantly different to that expected by the customer. Such differences can be explained in terms of the yield curve used for valuation or the method used to calculate discount factors but the most likely reason is that the dealer is building in a profit. In this situation what can a customer do?

It’s tricky but some novate the swap to a third party. This is where a third party takes over the rights and obligations for the swap either paying or receiving a fee dependent on the swap’s market value.

Credit risk

Swaps can create counterparty credit exposures. This is how. Suppose you enter a swap receiving a fixed rate of 5% and in a months time the market rate on that swap is 4%. You are receiving 1% more than the market.

You have a profit. You may even recognise this profit in your accounts. However if your counterparty defaulted you would not receive 5% and your mark-to-market profit would evaporate. For this reason every dealer knows that in order to enter a swap with a counterparty there should be sufficient credit availability for that counterparty. Credit risk is a real risk and in order to mitigate this risk a process called collateral management is used.

Collateral management values all the swaps (and other derivatives) with the counterparty in order to establish one net figure. Provided the appropriate documentation has been signed this net figure represents the counterparty credit exposure.

A collateral call is then made by the party with the positive value on the party with the negative value, cash normally being used as the collateral.

The process is then repeated on a daily basis. Changes in the in the market value of the trade portfolio then lead to further calls for collateral or the return of collateral.

What happens if your counterparty defaults? You can offset the value of collateral held against the positive value of the trade portfolio and in so doing mitigate your credit risk.

Summary

If you use IRS make sure you know what you are doing. You should be able to price the deal at its inception to ensure you don’t overpay. You should be able to value the deal throughout its life, this may be an accounting requirement it certainly show you your credit exposure.

Remember that breaking a swap before maturity can be less than straightforward but leaving a swap “open” after the underlying requirement has gone increases your risk.

Finally take advice from legal council to make sure you understand the documentation you sign. Banks can and will enforce collateral requirements and if you don’t adhere to them you can find your swap terminated using their valuation. Caveat Emptor.

First Published by Barbican Consulting Limited 2009