Swaps

Interest Rate Swaps

by

Akshit Gupta

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents the derivative contract of interest rate swaps used to hedge interest rate risk in financial markets.

Introduction

In financial markets, interest rate swaps are derivative contracts used by two counterparties to exchange a stream of future interest payments with another for a pre-defined number of years. The interest payments are based on a pre-determined notional principal amount and usually include the exchange of a fixed interest rate for a floating interest rate (or sometimes the exchange of a floating interest rate for another floating interest rate).

While hedging does not necessarily eliminate the entire risk for any investment, it does limit or offset any potential losses that the investor can incur.

Forward rate agreements (FRA)

To understand interest rate swaps, we first need to understand forward rate agreements in financial markets.

In an FRA, two counterparties agree to an exchange of cashflows in the future based on two different interest rates, one of which is a fixed rate and the other is a floating rate. The interest rate payments are based on a pre-determined notional amount and maturity period. This derivative contract has a single settlement date. LIBOR (London Interbank Offered Rate) is frequently used as the floating rate index to determine the floating interest rate in the swap.

The payoff of the contract is as shown in the formula below:

(LIBOR – Fixed Interest Rate) * Notional amount * Number of days / 100

Interest rate swaps (IRS)

An interest rate swap is a hedging mechanism wherein a pre-defined series of forward rate agreements to buy or sell the floating interest rate at the same fixed interest rate.

In an interest rate swap, the position taken by the receiver of the fixed interest rate is called “long receiver swaps” and the position taken by the payer of the fixed interest rate is called “long payer swaps”.

How does an interest rate swap work?

Interest rate swaps can be used in different market situations based on a counterparty’s prediction about future interest rates.

For example, when a firm paying a fixed rate of interest on an existing loan believes that the interest rate will decrease in the future, it may enter an interest rate swap agreement in which it pays a floating rate and receives a fixed rate to benefit from its expectation about the path of future interest rates. Conversely, if the firm paying a floating interest rate on an existing loan believes that the interest rate will increase in the future, it may enter an interest rate swap in which it pays a fixed rate and receives a floating rate to benefit from its expectation about the path of future interest rates.

Example

Let’s consider a 4-year swap between two counterparties A and B on January 1, 2021. In this swap, counterparty A agrees to pay a fixed interest rate of 3.60% per annum to counterparty B every six months on an agreed notional amount of €10 million. Counterparty B agrees to pay a floating interest rate based on the 6-month LIBOR rate, currently at 2.60%, to Counterparty A on the same notional amount. Here, the position taken by Counterparty A is called long payer swap and the position taken by Counterparty B is called the long receiver swap. The projected cashflow receipt to Counterparty A based on the assumed LIBOR rates is shown in the below table:

Table 1. Cash flows for an interest rate swap.
Cash flows for an interest rate swap
Source: computation by the author

In the above example, a total of eight payments (two per year) are made on the interest rate swap. The fixed rate payment is fixed at €180,000 per observation date whereas the floating payment rate depend on the prevailing LIBOR rate at the observation date. The net receipt for the Counterparty A is equal to €77,500 at the end of 5 years. Note that in an interest rate swap the notional amount of €10 million is not exchanged between the counterparties since it has no financial value to either of the counterparties and that is why it is called the “notional amount”.

Note that when the two counterparties enter the swap, the fixed rate is set such that the swap value is equal to zero.

Excel file for interest rate swaps

You can download below the Excel file for the computation of the cash flows for an interest rate swap.

Download the Excel file to compute the protective put value

Related Posts

   ▶ Jayati WALIA Derivative Markets

   ▶ Akshit GUPTA Forward Contracts

   ▶ Akshit GUPTA Options

Useful resources

Hull J.C. (2015) Options, Futures, and Other Derivatives, Ninth Edition, Chapter 7 – Swaps, 180-211.

www.longin.fr Pricer of interest swaps

About the author

Article written in December 2022 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Derivatives Market

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Derivatives Market

Jayati WALIA

In this article, Jayati WALIA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents an overview of derivatives market.

Introduction

A financial market refers to a marketplace where various kinds of financial securities such as stocks, bonds, commodities, etc. are traded. The term ‘market’ can also refer to exchanges that are legal organizations that facilitate the trade of financial securities between buyers and sellers. In any case, these markets are categorized based of the type of financial securities that are traded through them. One such financial market is the Derivatives Market.

Derivatives market thus refers to the financial marketplace where derivative instruments such as futures, forwards and options contracts are traded between counterparties.

It was during the 1980s and 1990s that the financial markets saw a major growth in the trade of derivatives. A derivative is a financial instrument whose value is derived from the value of an underlying asset such as stocks, bonds, currencies, commodities, interest rates and/or different market indices. These underlying assets have fluctuating prices and returns, and derivatives provides a means to investors to reduce the risk exposure and leverage profits on these assets. Thus, derivatives are an essential class of financial instruments and central to the modern financial markets providing not just economic benefits but also resilience against risks. The most common derivatives include futures, forwards, options and swap contracts.

As per the European Securities and Markets Authority (ESMA), derivatives market has grown impressively (around 24 percent per year in the last decade) into a truly global market with over €680 trillion of notional amount outstanding. The interest rate derivatives (IRDs) accounted for 82% of the total notional amount outstanding followed by currency derivatives at 11%.

Main types of derivative contracts

Derivatives derive their value from an underlying asset, or simply an ‘underlying’. There is a wide range of financial instruments that can be an underlying for a derivative such as equities or equity index, fixed-income instruments, foreign currencies, commodities, and even other securities. And thus, depending on the underlying, derivative contracts can derive their values from corresponding equity prices, interest rates, foreign exchange rates, prices of commodities and probable credit events. The most common types of derivative contracts are elucidated below:

Forwards and Futures

Forward and futures contracts share a similar feature: they are an agreement between two parties to buy or sell a specified quantity of an underlying asset at a specified price (or ‘exercise price’) on a predetermined date in the future (or ‘expiration date’). While forwards are customized contracts i.e., they can be tailor-made according to the asset being traded, expiry date and price, and traded Over-the-Counter (OTC), futures are standardized contracts traded on centralized exchanges. The party that buys the underlying is said to be taking a long position while the party that sells the asset takes a short position and both parties are obligated to fulfil their part of the contract.

Options

An option contract is a financial derivative that gives its holder the right (but not the obligation) to trade an underlying asset at a price set in advance irrespective of the market price at maturity. When an option is bought, its holder pays a fixed amount to the option writer as cost for this flexibility of trading that the option provides, known as the premium. Options can be of the types: call (right to buy) or put (right to sell).

Swaps

Swaps are agreements between two counterparties to exchange a series of cash payments for a stated period of time. The periodic payments charged can be based on fixed or floating interest rates, depending on contract terms decided by the counterparties. The calculation of these payments is based on an agreed-upon amount, called the notional principal amount (or just notional).

Exchange-traded vs Over-the-counter Derivatives Market

Exchange-traded derivatives markets

Exchange-traded derivatives markets are standardized markets for derivatives trading and follows rules set by the exchange. For instance, the exchange sets the expiry date of the derivatives, the lot-size, underlying securities on which derivatives can be created, settlement process etc. The exchange also performs the clearing and settlement of trades and provide credit guarantee by acting as a counterparty for every trade of derivatives. Thus, exchanges provide a transparent and systematic course of action for any derivatives trade.

Over-the-counter markets

Over-the-counter (also known as “OTC”) derivatives markets on the other hand, provide a lesser degree of regulations. They were almost entirely unregulated before the financial crisis of 2007-2008 (also a time when derivatives markets were criticized, and the blame was placed on Credit Default Swaps). OTCs are customized markets and run by dealers who hedge risks by indulging in derivatives trading.

Types of market participants

The participants in the derivative markets can be categorized into different groups namely,

Hedgers

Hedging is a risk-neutralizing strategy when an investor seeks to protect a current or anticipated position in the market by limiting their risk exposure. They can do so by taking up an offset or counter position through derivative contracts. Parties such as individuals or companies who perform hedging are called Hedgers. The hedger thus aims to eliminate volatility against fluctuating prices of underlying securities and protect herself/himself from any downsides.

Speculators

Speculation is a very common technique used by traders and investors in the derivatives market. It is based on when traders have a strong viewpoint regarding the market behavior of any underlying security and though it is risky, if the viewpoint is correct, the speculation may reward with attractive payoffs. Thus, speculators use derivative contracts with a view to make profit from the subsequent price movements. They do not have any risk to hedge, in fact, they operate at a relatively high-risk level in anticipation of profits and provide liquidity in the market.

Arbitrageurs

Arbitrage is a strategy in which the participant (or arbitrageur) aims to make profits from the price differences which arise in the investments made in the financial markets as a result of mispricing. Arbitrageurs aim to earn low risk profits by taking two different positions in the same or different contracts (across different time periods) or on different exchanges to in-cash on price discrepancies or market inefficiencies.

Margin Traders

Margin is essentially the collateral amount deposited by an investor investing in a financial instrument to the counterparty in order to cover for the credit risk associated with the investment. In margin trading, the trader or investor is not required to pay the total value of your position upfront. Instead, they only need pay the margin amount which may vary and are usually fixed by the stock exchanges considering factors like volatility. Thus, margin traders buy and sell securities over a single session and square off their position on the same day, making a quick payoff if their speculations are right.

Criticism of derivatives

While derivatives provide numerous benefits and have significantly impacted modern finance and markets, they pose many risks too. In a 2002 letter to Berkshire Hathaway shareholders, Warren Buffet even described derivatives as “financial weapons of mass destruction”.

Derivatives are more highly leveraged due to relatively relaxed regulations surrounding them, and where one may need to put up half the money or more with buying other securities, derivatives traders can get by with just putting up a few percentage points of the total value of a derivatives contract as a margin. If the price of the underlying asset keeps falling, covering the margin account can lead to enormous losses. Derivatives are thus often criticized as they may allow investors to obtain unsustainable positions that elevates systematic risk so much that it can be equated to legalized gambling. Derivatives are also exposed to counterparty credit risk wherein there is scope of default on the contract by any of the parties involved in the contract. The risk becomes even greater while trading on OTC markets which are less regulated.

Derivatives have been associated with a number of high-profile credit events over the past two decades. For instance, in the early 1990s, Procter and Gamble Corporation lost more than $100 million in transactions in equity swaps. In 1995, Barings collapsed when one of its traders lost $1.4 billion (more than twice its then capital) in trading equity index derivatives.

The amounts involved with derivatives-related corporate financial distresses in the 2000s increased even more. Two such events were the bankruptcy of Enron Corporation in 2001 and the near collapse of AIG in 2008. The point of commonality among these events was the role of OTC derivative trades. Being an AAA-rated company, AIG was being exempted from posting collateral on most of its derivatives trading in 2008. In addition, AIG was unique among CDS market participants and acted almost exclusively as credit protection seller. When the global financial crisis reached its peak in late 2008, AIG’s CDS portfolios recorded substantial mark-to-market losses. Consequently, the company was asked to post $40 billion worth of collateral and the US government had to introduce a $150 billion financial package to prevent AIG, once the world’s largest insurer by market value, from filing for bankruptcy.

Conclusion

Derivatives were essentially created in response to some fundamental changes in the global financial system. If correctly handled, they help improve the resilience of the system, hedge market risks and bring economic benefits to the users. Thus, they are expected to grow further with financial globalization. However, past credit events have exposed many weaknesses in the organization of their trading. The aim is to minimize the risks associated with such trades while enjoying the benefits they bring to the financial system. An important challenge is to design new rules and regulations to mitigate the risks and to promote transparency by improving the quality and quantity of statistics on derivatives markets.

Related posts on the SimTrade blog

   ▶ All posts about Options

   ▶ Alexandre VERLET Understanding financial derivatives: options

   ▶ Jayati WALIA Plain Vanilla Options

   ▶ Alexandre VERLET Understanding financial derivatives: forwards

   ▶ Alexandre VERLET Understanding financial derivatives: futures

   ▶ Alexandre VERLET Understanding financial derivatives: swaps

Useful resources

Role of Derivatives in the 2008 Financial Crisis

ESMA Annual Statistical Report 2020

About the author

The article was written in August 2021 by Jayati WALIA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Understanding financial derivatives: swaps

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Understanding financial derivatives: swaps

Alexandre VERLET

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) explains why financial markets invented swaps and how they function.

The origins of swaps

The origins of swaps lie in ‘parallel loans’. In the 1970s, while floating exchange rates were common, the transfer of capital between countries remained tightly controlled. Multinational companies were particularly affected when they transferred capital between their subsidiaries and their headquarter. In order to solve this problem, parallel loans were set up. To understand the principle of these loans, let us take an example. Michelin and General Motors (GM) are two multinational companies. Michelin, a French company, has a subsidiary in the United States, and General Motors, a US company, has a subsidiary in France. Suppose that both companies want to transfer funds to their respective subsidiary. In order to circumvent international transfers, the two parent companies can simply agree to lend an equivalent amount of money to their counterparty’s subsidiary. For example, Michelin’s parent company would transfer X amount in euros to General Motors’ French subsidiary, while General Motors’ parent company would transfer the equivalent amount in dollars to Michelin’s US subsidiary. With swaps, companies are also able to have access to cheaper capital and better interest rates.
As this type of financing arrangement became more popular, it became increasingly difficult for companies to find counterparties with exactly the opposite needs. In order to centralise supply and demand, financial institutions began to act as intermediaries. In doing so, they improved the original product (parallel loans) to swaps.

How big is the swap market?

The word swap comes from the English verb “to swap”. In finance, swap means an exchange of flows (and sometimes capital). Financial institutions were the first to realise the huge potential of the swaps market. In order to satisfy the growing demand, an interbank market was created. In the wake of this, several financial institutions became market makers (or dealers) to organize the market and bring liquidity to market participants. The role of a market maker is to offer bid and ask prices in a continuous manner. The financial institutions involved in the swap market have also come together in an association called the International Swap Dealers Association (ISDA). As a result, swaps became the first OTC market to have a standardised contract, further accelerating their development. With this success, the ISDA contract quickly became the standard for other OTC derivatives markets, allowing ISDA to expand its area of influence. The latter will be renamed the International Swaps and Derivatives Association. The ISDA ‘s work turned out to be an unprecedented success in the financial world. According to figures from the Bank for International Settlements (BIS), more than 75% of the outstanding amounts in the OTC markets involve swaps.

The GDP worldwide is about ten times less than the total known outstanding amounts in the OTC derivatives markets! The reason for this discrepancy is probably the almost systematic use of leverage in transactions involving derivatives.

Interest rate swaps

Interest rate swaps are a must in the OTC derivatives markets, with the notional amount outstanding in OTC interest rate swaps of over $400 trillion. In their most basic form (plain vanilla swaps), they provide a very simple understanding of how swaps work.
A plain vanilla swap is a financial mechanism in which entity A pays a fixed interest rate to entity B, and entity B pays a floating interest rate to entity A, all in the same currency. With this mechanism, it is possible to transform a fixed interest rate into a floating rate, and vice versa. It should be noted, however, that the plain vanilla is not the only type of interest rate swap. The definition of all interest rate swaps is as follows: an interest rate swap is a transaction in which two counterparties exchange financial flows in the same currency, for the same nominal amount and on different interest rate references. This definition obviously includes plain vanilla (a fixed rate against a floating rate in the same currency), but also other types of interest rate swaps (e.g. a floating rate against another floating rate in the same currency).

Currency Swaps

Currency swaps are the oldest family of swaps. A currency swap is a transaction in which two counterparties exchange cash flows in different currencies for the same nominal amount. Unlike interest rate swaps, in the case of currency swaps there is an exchange of the nominal amount at the beginning and end of the swap. Currency swaps can be classified into four categories, depending on the nature of the rates used:

Counterparty A (fixed rate) versus counterparty B (fixed rate)

Counterparty A (fixed rate) versus counterparty B (floating rate)

Counterparty A (floating rate) versus Counterparty B (fixed rate)

Counterparty A (floating rate) versus Counterparty B (floating rate)

This type of swap can reverse the currencies of two debts denominated in different currencies and also the type of interests (fixed or floating). In other words, companies use it to transform an interest payment in euros into an interest payment in dollars for instance, and a fixed interest into a floating interest for example.

Equity and commodity swaps

Interest rate and currency swaps are by far the most common families of swaps used by market participants. However, there are other types of swaps, notably equity swaps and commodity swaps. Since indices are made up of a set of stocks, equity swaps work in a similar way to index swaps. It is a matter of exchanging an interest rate (fixed or variable) against the performance of a stock or an index. Swaps have also been put in place for the commodity market. A commodity swap allows a counterparty to buy (or sell) a given quantity of a commodity at a future date, at a price fixed in advance, and to sell (or buy) a given quantity of a commodity at a future date, at a price varying according to supply and demand in the market.

Let us consider company A, that owns a certain amount of gold. The value of this asset is not stable, as it varies according to the price of gold on the markets. In order to protect itself against this over a specific time period, company A can simply ask its bank to arrange a swap in which the company exchanges (“swaps”) the variable price of its gold stock against a price fixed in advance. The mechanism for this type of swap is quite similar to the mechanism for equity swaps, which we discussed previously.

We could think of infinitely more types of swaps, as it has become a very common way to hedge against risk. Perhaps the most famous one would be the Credit Default Swap (CDS), which is a credit derivative that allows its buyer to protect himself against the risk of default of a company. In return, the buyer of the CDS pays a periodic premium to the seller of the CDS. The CDS has played an important role in the 2008 financial crisis, but this story deserves an article of its own.

Useful resources

ISDA

Related posts on the SimTrade blog

   ▶ Alexandre VERLET Understanding financial derivatives: options

   ▶ Alexandre VERLET Understanding financial derivatives: futures

   ▶ Alexandre VERLET Understanding financial derivatives: forwards

   ▶ Akshit GUPTA Currency swaps

About the author

This article was written in May 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).