(An excerpt from my MSc dissertation)

Hull describes an Interest Rate Swap as a “private agreement between two companies to exchange cash flows in the future according to a prearranged formula”. The simplest form of swap contract involves two counterparties, one paying the other a cash flow equivalent to fixed interest on a negotiated capital sum, and the opposite party reciprocating with a cash flow on the same capital amount, but with a floating rate of capital. The respective interest rates are set when the swap deal is negotiated, the fixed rate remaining constant for the duration of the swap, and the floating rate is set in relation to LIBOR, the London Inter-Bank Offer Rate, which is the rate of interest at which banks loan cash to each other. There are differing LIBOR rates depending on the tenor of the deposit, for example 1-month LIBOR, 3- month and so forth. The LIBOR rate used when negotiating a swap determines how often the floating rate is updated, and how frequently payments are actually made. Typically, the floating rate will be LIBOR plus a certain percentage, and this premium over LIBOR does remain fixed for the duration of the swap.

Swaps originated because of a phenomenon known as “comparative advantage”. This means that different companies are able to raise capital at different rates in different markets. For example, one company may be able to enter into fixed-rate loans at more advantageous rates than another, usually as a result of have a higher credit rating, earned through its commercial activities and previous activity in that capital market. Similarly, a company may enjoy a relationship with the floating rate market, able to raise capital more cheaply than other companies accessing the same market (that is, the premium it must pay over LIBOR is smaller). It must be noted that in general company with a lower credit rating will find capital more expensive in both fixed and floating rate markets, however swaps are possible because the difference in interest rate offered to both companies for fixed rate capital may be different from the spreads that each would pay in the floating rate market. The reason for this is again related to the credit ratings of the companies. The fixed rate is likely to reflect the rate at which a company can issue medium-term bonds, whereas the floating rate is likely to reflect the rate at which short-term loans could be taken out.

A fixed rate for a long term serves to lock in a rate of return for the lender, but introduces the risk that the borrower could default, and also that macroeconomic factors mean that better returns could be obtained elsewhere. A short-term loan can have its interest rate adjusted as it is rolled over, or in extreme circumstances, a lender can refuse to roll over the loan to the next period, and retrieve the capital. Therefore, floating rate spreads (the premium over LIBOR) are tighter for short tenors, because it is easier for a lender to analyze risk and assign a credit score over the short term, making the probability of default for either company similar (assuming that they are broadly similar companies). The risk is also lessened by the ability of the lender to vary the spread as a condition of rolling over the loan, so if the lender appears to be at greater risk of default, a higher spread will serve to offset this risk. However, as the term becomes longer, the probability of the least credit worthy company defaulting increases more rapidly that the probability of the more credit worthy company defaulting, all other factors being equal. This risk is offset by the spread on longer tenors being greater for the company with the lower credit score. The fact that different types of instruments are used for different borrowing terms prevents comparative advantage from being arbitraged away.

If the companies are willing to take the risk onto their books, then both may profit from this apparent anomaly. This is because the terms of a swap deal lock in the interest rate and the spread over LIBOR, respectively, and it can be exploited in a situation in which the company with the higher credit rating wishes to access floating rate funds, and the company with the lesser credit rating requires fixed rate funds. The reason companies would want to do this is their commercial activities may require it, for example, to assist with budgeting for fixed costs, or even to take a speculative position. The company with the higher credit rating borrows fixed rate funds, at the advantageous rate available to it, and agrees to pay LIBOR for a particular tenor on that sum to the less credit worthy company (plus the fixed rate to the lenders). This company borrows floating rate at LIBOR, plus a spread, and pays a fixed interest rate to the first company and a floating interest rate to its creditors. The net position of this company is therefore that it is paying a fixed rate to its partner in the swap deal, and only the fixed premium above LIBOR to its creditors, since it is receiving the current LIBOR rate in cash flow from its partner in the swap deal, effectively converting a floating rate into a fixed. It must be noted that the principal amounts of the loans are not exchanged, only the cash flows, since they are equivalent, and avoiding settlement risk. Similarly, the fixed-rate borrower is now paying the floating LIBOR rate, plus a fixed rate to its creditors, but also receiving a fixed rate from the original floating-rate borrower, meaning that the net cash flow is LIBOR plus a spread. If there were no default of risk, this would be the same as entering into a series of forward contracts.

The fixed rate of the cash flow between these two counterparties is calculated from the difference in the respective interest rates offered to each counterparty in the fixed rate markets, minus the difference in the interest rate offered to each counterparty in the floating rate market. The net result is that each of the counterparties to the swap deal improves their position by half this rate, and at the same time is better able to fulfill its commercial borrowing requirements for operations outside the capital markets. However, in practice, it would rare for two companies to negotiate a swap deal between themselves, partly because it would be time consuming a difficult to find a counterparty with matching needs, and partly because of the risk being taken that the counterparty may default. Swap deals are therefore brokered by third parties such as banks, who assume the risk, and may enter into one leg of a swap deal before finding a counterparty for the other leg, a process known as “warehousing”. The process of arranging offsetting legs greatly benefits from a common protocol for exchanging details of a swap between counterparties and banks. Swaps are accounted “off balance sheet”, and are popular for this reason, as swap dealing does not adversely affect a bank’s capital ratio. In this case, the total potential gain from the deal would need to be split three ways. If either company dues default, the intermediary will continue to honor its commitment to the other, since the single swap deal is actually two separate contracts, and the amount of the commission charged by the intermediary will offset this risk. The actual spread is determined by market forces of supply and demand, for example at a given moment, there may be more market participants wishing to enter into fixed rather than floating rate deals in response to macroeconomic factors, lowering swap spreads, similarly greater demand for floating rate means swap spreads will rise.

Other types of swaps include currency swaps (exchanging principal equivalent at the time the deal was entered into and fixed-rate cash flow in different currencies, perhaps to exploit comparative advantage in a company’s home market), amortizing swaps (where the principal diminishes throughout the period corresponding to the amortization on a loan) and even commodity swaps, where the floating leg of a deal is actually delivery of a commodity.

References:

  • Introduction to the Futures and Options Market, John Hull, Prentice Hall 1995

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