In finance , an interest rate swap ( IRS ) is an interest rate derivative (IRD) . In particular it is a linear IRD and one of the most liquid , benchmark products. It has associations with forward rate agreements (FRAs) , and with zero coupon swaps (ZCSs) .

General Description

[1] An interest rate swap’s (IRS’s) effective description is a derivative contract, agreed between two counterparties , which specifies the nature of an exchange of payments benchmarked against an interest rate index. The most common IRS is a fixed floating swap, whereby one party will make payments to the other based on an initially agreed rate of interest, to receive back payments based on a floating interest rate index. Each of these series of payments is termed a ‘leg’, so a typical IRS has both a fixed and a floating leg. (IBOR) of the IRS, for example LIBOR in USD, GBP, EURIBOR in EUR or STIBOR in SEK. To completely determine any IRS a number of parameters must be specified for each leg; The notional principal amount (or varying notional schedule), the start and end dates and date scheduling, the fixed rate, the chosen floating interest rate index tenor, and day count conventions for interest calculations.

Extended description

As OTC instruments, interest rate swaps (IRSs) can be customized in a number of ways and can be structured to meet the specific needs of the counterparties. For example; Payment dates could be irregular, the notional of the swap could be amortized over time, reset dates (or fixing dates) of the floating rate could be irregular, mandatory break clauses may be inserted into the contract, etc. A common form of customization is often present in new issue swaps where the fixed cashflows are designed to replicate those cashflows received as the coupons on a. The interbank market , however, has only a few standard types. Each currency has its own standard market conventions concerning the frequency of payments, The day count conventions and the end-of-month rule. [2]

There is no consensus on the scope of naming convention for different types of IRS. Even a broad description of IRS contracts only includes those in which the legs are denominated in the same currency. It is generally accepted that the swaps of similar nature are denominated in different currencies are called cross currency basis swaps . Swaps which are denominated in another currency are called quantos .

In traditional interest rate derivative terminology an IRS is a fixed leg versus floating leg derivative contract referencing an IBOR as the floating leg. If EONIA, SONIA, FFOIS, etc. are the same, Then this type of swap is referred to as an overnight indexed swap (OIS) . Some financial literature may classify OIS as a subset of IRSs and other literature.

Fixed leg versus fixed leg swaps are rare, and generally constitute a form of specialized loan agreement.

Float leg versus float leg swaps are much more common. These are typically termed (single currency) basis swaps (SBSs). The legs on SBSs will necessarily be different interest indexes, such as 1M, LIBOR, 3M LIBOR, 6M LIBOR, SONIA, etc. The pricing of These swaps requires a spread Often quoted in basis point to be added to one of the floating legs in order to Satisfy value equivalence.

Uses

Interest rate swaps are used to hedge against or speculate on changes in interest rates.

Interest rate swaps are also used by the hedge funds or other investors. Traditionally, fixed income investors who are expected to make cash purchases. Today, investors with a similar view could enter a fixed interest rate swap; As falls, investors would pay a lower floating rate in exchange for the same fixed rate.

Interest rate swaps are also popular for arbitrage opportunities they provide. Varying levels of creditworthiness means that it is often a positive quality differential that allows both parties to benefit from an interest rate swap.

The interest rate swap market in USD étroitement is linked to the Eurodollar futures market trades qui Among Others at the Chicago Mercantile Exchange .

Risks

Interest rate swaps exposes users to many different types of financial risk. [1]

Predominantly they expose the user to market risks. The value of an interest rate swap market will change as interest rates rise and fall. In market terminology this is Often Referred to as delta risk. (Where various IBOR tenor indexes can deviate from one another) and reset risks (where the IBOR indexes are subject to daily fluctuation). Interest rate swaps aussi exhibit gamma delta risk whereby Their Risk Increases or decreases as market interest rates fluctuate.

Uncollateralised interest rate swaps (that are those executed bilaterally without a credit support annex (CSA) in place) exposes the trading counterparties to funding risks and credit risks. Funding risks because the value of the swap could deviate to become unaffordable and can not be funded. Credit risks because of the counterparty counterparty, for which the value of the swap is positive, will be concerned about the counterparty counterparty defaulting on its obligations.

Collateralised interest rate swaps exposes the users to collateral risks. Depending on the terms of the CSA, the type of collateral that is permitted may become more or less expensive due to other extraneous market movements. Credit and funding risks still exist for collateralised trades but to a much less extent.

Due to regulations set out in the Basel III Regulatory Frameworks. Dependent on their specific nature interest rate swaps could command more capital usage and this can deviate with market movements. Thus capital is another concern for users.

Reputation risks also exist. The mis-selling of swaps, over-exposure of municipalities to derivative contracts, and IBOR are examples of high-profile cases.

Hedging interest rates can be complicated and relies on numerical processes of well designed risk models to suggest reliable benchmark trades that mitigate all market risks. The other, aforementioned risks must be hedged using other systematic processes.

Market-Making

The market-making of IRSs is an involved process involving multiple tasks; Curve construction with reference to interbank markets, individual derivative contract pricing, risk management of credit, cash and capital. The cross-disciplines required include quantitative analysis and mathematical expertise, disciplined and organized approach to profits and losses, and coherent psychological and subjective assessment of financial market information and price-taker analysis. The time sensitive nature of markets also creates a pressurized environment. Many tools and techniques have been designed to improve efficiency and consistency. [1]

Trivia

It icts December 2014 statistics release, the Bank for International Settlements Reported That interest rate swaps Were the Largest component of the global OTC derivative market Representing 60% of it, with the notional amountoutstanding in OTC interest rate swaps of $ 381 trillion, and the gross Market value of $ 14 trillion. [6]

Interest rate swaps can be traded as an index through the FTSE MTIRS Index .

In June 1988 the Audit Commission was tipped off by someone working on the swaps desk of Goldman Sachs that the London Borough of Hammersmith and Fulham had a massive exposure to interest rate swaps. When the commission contacted the council, the chief executive said to him, “everybody knows that interest rates are going to fall”; The treasurer was a nice little earner. The Commission’s Controller, Howard Davies , realised that the council had put all its positions on interest rates going down and ordered an investigation.

By Queen’s Counsel . Although they did not agree, the commission preferred the opinion which made it ultra vires for councils to engage in interest rate swaps. Moreover, interest rates had increased from 8% to 15%. The auditor and the commission then went to court and had the contracts declared illegal (appeals all the way to the House of Lords failed in Hazell v Hammersmith and Fulham LBC ); The five banks involved lost millions of pounds. Many other local authorities have been engaged in interest rates in the 1980s. [7] This resulted in the qui Several boxes in banks Generally Lost Their claims for compound interest is debts to councils, finalised in Westdeutsche Landesbank Girozentrale v Islington London Borough Council . [8]

Further reading

  • JHM Darbyshire (2017). Pricing and Trading Interest Rate Derivatives (2nd ed. 2017 ed.). Aitch and Dee Ltd. ISBN  978-0995455528 .
  • Leif BG Andersen, Vladimir V. Piterbarg (2010). Interest Rate Modeling in Three Volumes (1st ed. 2010 ed.). Atlantic Financial Press. ISBN  978-0-9844221-0-4 .

References

  1. ^ Jump up to:e Pricing and Trading Interest Rate Derivatives: A Practical Guide to swaps , JHM Darbyshire, 2017, ISBN 978-0995455528
  2. Jump up^ “Interest Rate Instruments and Market Conventions Guide” Quantitative Research, OpenGamma, 2012.
  3. Jump up^ Multi-Curve Valuation Approaches and their Application to Hedge Accounting according to IAS 39, Dr. Dirk Schubert,KPMG
  4. Jump up^ M. Henrard (2014). Interest Rate Modeling in the Multi-Curve Framework: Foundations, Evolution and Implementation. Palgrave MacmillanISBN 978-1137374653
  5. Jump up^ See section 3 of Marco Bianchetti and Mattia Carlicchi (2012). Interest Rates after The Credit Crunch: Multiple-Curve Vanilla Derivatives and SABR
  6. Jump up^ “OTC derivatives statistics at end-December 2014” (PDF) . Bank for International Settlements.
  7. Jump up^ Duncan Campbell-Smith, “Follow the Money: The Audit Commission, Public Money, and the Management of Public Services 1983-2008”, Allen Lane, 2008, chapter 6passim.
  8. Jump up^ [1996]UKHL 12, [1996] AC 669