How to use the interest rate swap

How To Use The Interest Rate Swap

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How To Use The Interest Rate Swap

The basic structure of an interest rate swap consists of the exchange between two counterparties of fixed-rate interest for floating-rate interest in the same currency calculated by reference to a mutually agreed notional principal amount. This principle amount, which would normally equate to the underlying assets or liabilities being  ―swapped by the counterparties,  is applicable solely for the calculation of the interest to be exchanged under the swap. At no time it is physically passed between the counterparties. The counterparties are able to convert an underlying fixed-rate asset/ liability and vice-versa, through this straight forward swap structure. The majority of the interest rate swap transactions are driven by the cost savings to be obtained by each of the counterparties. These cost savings are substantial and result from differentials in the credit standing of the counterparties and other structural considerations.

Generally, investors in fixed-rate instruments are more sensitive to credit quality than floating-rate bank lenders. Accordingly, a greater premium is demanded of issuers of lesser credit quality in the fixed-rate debt markets than in the floating rate bank lending market. The counterparties to an interest rate swap may, therefore, obtain an arbitrage advantage by accessing the market in which they have the greatest relative cost advantage and then entering into an interest rate swap to convert the cost of the funds so raised from a fixed rate to a floating rate basis or vice-versa.

This ability to transfer a fixed rate cost advantage to floating rate liabilities has led to many high-quality credits issuing fixed-rate Euro bonds purely to ―swap‖ and obtain, in many cases, sub-LIBOR funding. The use of this structure in a fixed fate Euro bond issue enables the issuer to obtain substantial funding at points below LIBOR. This most attractive of rates is made possible by (i) the careful timing of the Eurobond issue to ensure its success at the finest of rates and (ii) the use of exact hedging and a deferred swap accrual date to ensure the best possible swap terms for the issuer. The counterparty to the swap may be a combination of banks and corporate clients. The banks may want to hedge their fixed rate income into a floating rate return that fully matched their floating rate liabilities in order to alleviate interest rate exposure. The corporate clients may want to hedge their floating rate binding into fixed-rate liabilities for size and maturity unavailable in the direct fixed-rate debt market. Acting as principal, the intermediary may be able to provide both the banks and its corporate clients with swap terms to meet their exact requirements and then subsequently lock the Euro bond issuer into an opposite swap when the Euro bond market was most receptive to the issue. Interest rate swaps also provide an excellent mechanism for entities to effectively access markets that are otherwise closed to them. The ability to obtain the benefits of markets without the need to comply with the prospectus disclosures, credit ratings, and other formal requirements and other formal requirements provides an additional benefit, especially for private companies. An excellent example of the swap market‘s flexibility in providing benefits is the growth of interest rate swaps using commercial paper as the underlying floating rate basis. The interest rate swap market also provides finance money with the perfect mechanism for managing interest rate costs and exposure whilst leaving the underlying source of funds unaffected. For example, the cost of fixed-rate funding may be reduced in a declining interest-rate environment through the use of the interest rate swap technique whilst leaving the underlying funding in place.

After close observation of the interest rate swap market it is experienced that it possesses certain characteristics of a fairly well-organized financial market. There are a larger number of players with fairly distinct roles in the market, there are several different structures of the market in which certain players specialize. There is both a primary and a secondary market in interest swaps. Not only this, but there is also sufficient liquidity in both the primary and secondary markets of certain sectors such that a few players do trade or make markets in interest swaps and in even fewer cases have significant capital commitments to the swap market.

After the above explanation, we are in a position to say that swap market activities can be classified into two sectors:

1. The primary market and,
2. The secondary market.

The Primary market has further divisions like –source of raw material for an interest rate swap-bank, financial market funding, hedging instruments, and the securities markets. European bond market can be taken as an example. The primary sector can be distinguished by activities like maturity and type of player. The short term sector of the primary market is essentially an interbank market dominated by the funding and hedging activities of both large and small banks. The banks are both providers and takers in the segment of the market depending on the structure of their asset base. Since it is extremely volatile in price in terms of spread, the market-making or position-taking is, therefore only for the most experienced dealers. For such dealers profit potential is high and risks in position – taking while similarly high, are manageable due to the impressive array of instruments available to manage risks. New York is the center of this market with London and Tokyo following it. The main participants are the banks which include a number of brokers who have extended their normal money market dealing activities with banks to include interest swap activities. Success in this segment of the primary market does not depend only on the close integration of an institution‘s treasury and swap operations, but also on distribution and in particular, the ability to move positions quickly due to the price volatility and risks inherent to the market. Inventory also quickly becomes stale in the short-term market because most transactions are done on a spot‘ basis holding a position for a period of time may, therefore, mean one‘s inventory may not move irrespective of price. However, the growth of the secondary market in the short term swaps has decreased the risks of position-taking in the short term secondary market. The use of financial futures has been the special feature of the secondary market which creates “the other side” of an interest swap. While financial futures-based swaps are highly complex to execute properly, the very quick and sharp movements in this market and hence, the need to wind and un-wind these structures to maximize profits has increased the liquidity in the secondary market.

Excepting the yield, the primary interest rate swap market is dominated by securities transactions and particularly the Eurodollar bond market. This market segment is very large. It is estimated that some 75% of all Eurodollar bond issues are swapped and the dollar fixed-rate Eurobond market is currently running at an annual rate of $50 billion-plus. The Eurodollar bond market never closes due to interest rate levels. Issuers who would not come to market because of high-interest rates now do so to the extent that a swap is available. The firms that now dominate lead management roles in the Eurodollar bond market all have substantial swap capabilities and this trend will continue. Pricing in this segment of the market is exclusively related to the U.S. Treasury rates for comparable maturities and is marked by the relative stability of these spreads by comparison to the short-term market. The size of the Eurobond issues and the oversupply of entities able and willing to approach the Eurobond market to swap into floating rate funds, most major houses in the swap market now enter into swap agreements with an issuer without a counterparty, on the other side.

The warehousing activity is normally hedged in the U.S. Treasury of the financial futures market, leaving the warehouse manager with a spread risk, or the difference between the spread at which he booked the swap with the issuer and where he manages to find a matched counterparty. The relative stability of spreads and a positively sloped yield curve have allowed the market to function reasonably well on this basis with only occasional periods of severe oversupply in any particular maturity. The major houses tend to spread their inventory across the yield curve to reduce risk and to ensure ready availability of a given maturity for particular clients‘ requirements.

Bids for bond-related swaps tend to differ between the major houses by only a few basis points: the swap market is quite efficient in price given the few houses who deal in bond market size and maturities. Hence, a premium is placed on creating bond structures that offer the fixed-rate issuer a lower cost and therefore, a better spread LIBOR. Apart from creative bond/ swap structures, the key to successfully operating in this segment of the market for the bond/ swap arranger has been the development of a highly refined sense of timing for the underlying issue. While finding a window in the Eurodollar bond market has always been the sine  qua non for a successful lead manager, with the advent and development of the swap market, the focus of the potential lead manager has shifted from an investor window to a spread window. Given that the long term swap market operates on a relatively stable spread level versus US Treasuries and the Eurodollar bond market is notoriously volatile versus Treasuries for different types of issuers, a similar premium to that of creativity applies to the lead manager who can locate a spread window for a particular type of issuer. This creativity and search for a spread window has sometimes led to mid-priced and/ or virtually incomprehensible bond structures but more often than not, bond/ swap structures so created have provided value to both the Euro-bond investor and issuer.
However, it is clear that (below) LIBOR spreads available to issuers have declined as the market has become more efficient in pricing the relative value of a given swap: at the outset of the market, a ―AAA issuer could reasonably expect to achieve 75-100 basis points below LIBOR on a bond/ swap; under current market conditions. This same issuer might expect only 25-30 basis points below on a ―plain vanilla‖ bond/ swap. Indeed many issuers, particularly commercial banks, now find it more cost-effective to approach the floating rate note market than the bond/ swap market. The lower spreads available have gone almost entirely to the benefit of the fixed-rate payer; intermediaries have seen their profit margins reduced to a very substantial degree in the primary market. This reduced profitability and lower spreads available has led, in turn, for most bond /swap arrangers to attempt to put potential counterparties in direct contact with each other and eliminate the intermediation of a commercial bank. This is most often a very difficult process due to timing and credit considerations but there is a strong incentive now among all parties concerned to see whether a direct-write is possible on a new issue.

The long term secondary market for interest swaps is a highly opportunistic segment of the market. As interest rate fluctuates, a fixed rate provider or taker may find that a substantial profit can be realized by reversing the original swap or canceling the original swap in return for an up-front cash payment. Several reasons can be cited for the slower rate of growth of the interest swap market. The few of them are explained below.

  1. Banks executing fixed-rate bond issues have represented a large portion of the provider side of the swap market. Most of the banks executed a bond/swap to gain long term floating rate funding for their long term floating rate loans and therefore, have no reason to
  2. The odd dates thrown off by swap reversals are often difficult to close in the market and thus what appears to be an interesting price on a spot basis may become substantially less interesting when the odd dates are taken into
  3. Many swap intermediaries do not make markets to their clients with whom the original swaps were written. In this case, now, the only option available is to execute a mirror swap for which up-fronts cash will be difficult to obtain and entails a doubling of credit risks for the reverser.

The market risk may be associated with the fixed flows, there is also risk associated with the LIBOR side. An additional potential risk can be assumed depending on the structure of the swap. When counterparty receives fixed payments semi-annually and pays LIBOR semi-annually, the potential risk is minimized.

Despite the problems explained above, the long term secondary market has shown good growth and several houses have sponsored the growth of this segment through the commitment of capital, personnel, and systems capabilities to market to making in long term swaps.