Risk Management Basics
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- Certificate in Quantitative Finance (CQF) Exam Guide
- Relative Risk Reduction Formula
Most recently, Citigroup’s Trading desk made $300million by trading Interest Rate Swaps.
What are Interest Rate Swaps?
In a nutshell, interest rate swap can be said to be a contractual agreement between two parties to exchange interest payments. The most common type of interest rate swap arrangement is one in which Party A agrees to make payments to Party B based on fixed interest rate, and Party B agrees to pay party A based on floating interest rate. In almost all cases the floating rate is tied to some kind of reference rate.
We look at Interest Rate Swaps in detail in this article, along with examples –
- Interest Rate Swaps Example
- Trading perspective of interest rate swap
- Uses of interest rate swap
- What is swap rate?
- What is a swap curve?
- Who are the market makers in Swaps?
- What are the risks involved in Swaps?
- What is in it for an investor in Swap?
Learn more about Swaps, valuation, etc in this detailed guide to Swaps
Interest Rate Swaps Example
Let’s see how interest rate swap works with this basic example.
Let’s say Mr. X owns a $1,000,000 investment that pays him LIBOR + 1% every month. LIBOR stands for London interbank offered rate and is one of the most used reference rates in case of floating securities. The payment for Mr. X keeps changing as the LIBOR keeps changing in the market. Now assume there is another guy Mr. Y who owns a $1,000,000 investment that pays him 1.5% every month. The payment received by him never changes as the interest rate assumed in the transaction if fixed in nature.
Now Mr. X decides that he doesn’t like this volatility and would rather have fixed interest payment, while Mr. Y decides to explore floating rate so that he has a chance of higher payments. This is when both of them enter into an interest rate swap contract. The terms of the contract state that Mr. X agrees to pay Mr. Y LIBOR + 1% every month for the notional principal amount $1,000,000. In lieu of this payment, Mr. Y agrees to pay Mr. X 1.5% interest rate on the same principal notional amount. Now let us see how the transactions unfold under different scenarios.
Scenario 1: LIBOR standing at 0.25%
Mr. X receives $12,500 from his investment at 1.25% (LIBOR standing at 0.25% and plus 1%). Mr. Y receives the fixed monthly payment of $15,000 at 1.5% fixed interest rate. Now, under the swap agreement, Mr. X owes $12,500 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions partially offset each other, the net transaction would lead Mr. Y to pay $2500 to Mr. X.
Scenario 1: LIBOR standing at 1.00%
Mr. X receives $20,000 from his investment at 2.00% (LIBOR standing at 1.00% and plus 1%). Mr. Y receives the fixed monthly payment of $15,000 at 1.5% fixed interest rate. Now, under the swap agreement, Mr. X owes $20,000 to Mr. Y, and Mr. Y owes $15,000 to Mr. X. The two transactions partially offset each other, the net transaction would lead Mr. X to pay $5000 to Mr. Y.
So, what did the interest rate swap did to Mr. X and Mr. Y? The swap has allowed Mr. X a guaranteed payment of $15,000 every month. If LIBOR is low, Mr. Y will owe him under the swap, however, if the LIBOR is high, he will owe Mr. Y. Either way, he will have the fixed monthly return of 1.5% during the tenure of the contract. It is very important to understand that under the interest rate swap arrangement, parties entering into the contract never exchange the principal amount. The principal amount is just notional here. There are many uses to which the interest rate swaps are put and we will discuss each one of them later in the article.
The trading perspective of interest rate Swap
Interest rate swaps are traded over the counter and generally, the two parties need to agree on two issues when going into the interest rate swap agreement. The two issues under consideration before a trade are the length of swap and terms of the swap. The length of a swap will decide the start and termination date of the contract while terms of the swap will decide the fixed rate on which the swap will work.
Uses of interest rate swap
- One of the uses to which interest rate swaps put to is hedging. In case an organization is of the view that the interest rate would increase in the coming times and there is a loan against which he/she is paying interest. Let us assume that this loan is linked to 3 month LIBOR rate. In case the organization is of the view that LIBOR rate will shoot up in the coming times, the organization can then hedge the cash flow by opting for fixed interest rates using an interest rate swap. This will provide some kind of certainty to the cash flow of the organization.
- The banks use interest rate swaps to manage interest rate risk. They tend to distribute their interest rate risk by creating smaller swaps and distributing them in the market through an inter-dealer broker. We will discuss this attribute and transaction in detail when we look at who are the market makers in the business.
- A huge tool for fixed income investors. They use it for speculations and market creation. Initially, it was only for corporates, but as the market grew people started perceiving the market as a way to gauge interest rate view held by the market participants. This is when many fixed income players started actively participating in the market.
- Interest rate swap works as an amazing portfolio management tool. It helps in adjusting the risk related to interest rate volatility. In the case of fund managers wants to work on long duration strategy, the long-dated interest rate swaps help in increasing the overall duration of the portfolio.
What is the swap rate?
Now when you have understood what is a swap transaction, it is very important to understand what is known as ‘swap rate’. A swap rate is the rate of the fixed leg of the swap as determined in the free market. So, the rate which is quoted by various banks for this instrument is known as swap rate. This provides an indication of what is the view of the market and if the firm believes it can stabilize cash flows buying a swap or can make a monetary gain doing so, they go for it. So, the swap rate is the fixed interest rate that the receiver demands in exchange for uncertainty which existed because of the floating leg of the transaction.
What is a swap curve?
The plot of swap rates across all the available maturities is known as the swap curve. It is very similar to the yield curve of any country where the prevailing interest rate across the tenure are plotted on a graph. Since swap rate is a good gauge of the interest rate perception, market liquidity, bank credit movement, the swap curve in isolation become very important for interest rate benchmark.
Generally, the sovereign yield curve and swap curve are of similar shape. However, at times there is a difference between the two. The difference between the two is known as ‘swap spread’. Historically this difference tended to be positive, which reflected higher credit risk with the banks compared to a sovereign. However, considering other factors which are indicative of supply-demand, liquidity, the U.S. spread currently is standing at negative for longer maturities. Please refer to the graph below for better understanding.
Please refer to the graph below for better understanding.
The swap curve is a good indicator of the conditions in the fixed income market. It reflects both bank credit situation coupled with the interest rate view of the market participants at large. In mature markets, the swap curve has supplanted the treasury curve as the main benchmark to price and trade corporate bonds and loans. It works like a primary benchmark in certain situation as it is more market driven and considers larger market participants.
Who are the market makers in Swaps?
Big investment firms along with commercial banks which have strong credit rating history are the largest swap market makers. They offer both fixed and floating rate options to investors who want to go for a swap transaction. The counterparties in a typical swap transaction are generally corporation, bank or an investor on one side and large commercial bank and investment firms on the other. In a general scenario, the moment a bank executes a swap, it usually offsets it through an inter-dealer broker. In the whole transaction, the bank keeps the fees for initiating the swap. In cases when the swap transaction is very large, the inter-broker dealer may arrange a number of other counterparties, in turn spreading the risk of the transaction. This results in a wider dispersion of the risk. This is how banks which hold interest rate risk, tries to spread the risk to the larger audience. The role of the market makers is to provide ample players and liquidity in the system.
What are the risks involved in Swaps?
Like in the case of non-government fixed income market, interest rate swap holds two primary risks. These two risks are interest rate risk and credit risk. Credit risk in the market is also known as counterparty risks. The interest rate risk arises because the expectation of interest rate view might not match with the actual interest rate. A Swap also has a counterparty risk, which entails that either party might adhere to contractual terms. The risk quotient for interest rate swap came at an all-time high in 2008 when the parties refused honoring the commitment of interest rate swaps. This is when it became important to establish a clearing agency to reduce the counterparty risk.
What is in it for an investor in Swap?
Over the year’s financial markets has constantly innovated and came up with great financial products. Each of them initiated in the market with an objective to solve some kind of corporate related problem and later became a huge market in itself. This is what has exactly happened with interest rate swaps or the swap category at large. The objective for the investor is to understand about the product and see where it can help them. The understanding of the interest rate swap can help an investor gauge an interest rate perception in the market. It can also help an individual decide on when to take a loan and when to delay it for a while. It can also be of help to understand the kind of portfolio your fund manager is holding and how over the years he or she is trying to manage the interest rate risk in the market. Swap is a great tool to manage your debt effectively. It allows the investor to play around with the interest rate and does not limit him with the fixed or floating option.