Interest rate swaps are a trading field not commonly explored by non-institutional investors, primarily due to the lack of online brokers’ media reporting and availability. Nevertheless, others, including Interactive Brokers, also give individual traders and investors access to these instruments.
Let’s go over what these are and their position in the world of finance.
What is an Interest Rate Swap?
An interest rate swap is a commodity derivative of interest rates that trades over the counter (OTC). It is an arrangement between two parties, for a given period of time, to swap one source of interest payments for another one.
Many goods of interest rate have a “fixed leg” and a “floating leg.” That means Party A will pay the fixed leg to Party B, while Party B will pay the floating leg to Party A. This is one way in which investors or traders can bet on interest rate changes. It’s a way for businesses, banks, and other companies to ensure interest rate fluctuations don’t negatively impact their finances.
Swaps exchanging fixed rate payments for floating rate payments are usually called “vanilla” swaps. Usually they are based on the London Interbank Offered Rate (LIBOR), which includes the US dollar (USD), EMU euro (EUR), UK pound (GBP), Japanese yen (JPY), and Swiss franc (CHF);
Besides those, some overnight rates include SHIBOR (Chinese renminbi), HIBOR (Hong Kong dollars), EURIBOR (euro), STIBOR (Swedish krona), and SOFR, which is related to the repurchase market for US Treasuries.
LIBOR is currently used by most major commercial banks to base floating credit products on. Barclays became the first to sell short-term commercial paper off SOFR in August 2018, as part of the expected phase out of LIBOR by 2021. It is being completed as rogue traders regularly rigged the rate.
Commercial and investment banks with high credit quality are market-makers in the swap market. These companies provide cash flows for those involved in the swap market, both at fixed rate and floating rate.
When a bank conducts a swap deal to a client, they will get a charge to facilitate the trade. A bank would usually conduct the transaction through an inter-broker dealer if a specific transaction is big. By selling it to many counterparties, this broker would then spread the interest rate risk associated with the instrument.
History and Purpose of the Interest Rate Swap
Originally, interest rate swaps helped firms to mitigate the risk associated with their floating-rate obligations. The swap enables them to easily convert this debt to fixed rates while collecting the payments at the floating rate.
To put it another way, the client will pay the fixed rate. Around the same time, they will obtain the cash payout from the exchange to cover the additional cost they will have to pay to investors from any negative impact on their debt – i.e., the interest rate the loan or bond is bound up to go up.
Enterprises can do the contrary, too. If the interest rate on their debt is set, they may opt to pay the floating rate.
Since interest rates are a market in themselves, and swaps represent future market expectations of their course, traders, investors, and other bank and non-bank institutions often have an interest in these instruments. These offer a way for market participants to bet on their course or express their views on the future shape of the yield curve (e.g., being bullish on some side and bearish on others), or the interest rate of one country versus that of another, and so on.
A swap rate exchange includes two key parties: receiver – pays the floating interest and payer – pays the fixed interest rate payer
What Specifically is the “Swap Rate”?
The swap rate is the fixed interest rate provided by the receiver to account for the risk inherent in having to pay the short-term floating rate (e.g., LIBOR) over the duration of the contract.
The perceptions of the investor on what this rate would be are expressed in the yield curve. The yield curve shows the market outlook for what different interest rates will be over time.
Below is a plot of the US Treasury curve along with the US swap rate curve.
The swap rate is regarded by traders as a very significant benchmark for interest rates. This not only represents regular rates embedded in the usual yield curve, but also liquidity, credit risk, and varying lengths of supply and demand for loan funds.
The LIBOR curve is much more important for banks than the US Treasury and other sovereign yield curves. That’s because the majority of corporate lending is tied to the LIBOR rate. Eighty-four per cent of US corporate loans are floating-rate, with the majority tied to LIBOR and the rest tied to the USD 3-month LIBOR rate. (By contrast, only 3% of the US bond market is floating.)
When an interest rate swap (trade) agreement is set, the value of the fixed rate flows of the swap will be equal to the floating rate payments as shown by the forward rate curve.
When swap-related interest rates change, investors and traders may alter the rate they need to enter swap transactions. In the graph shown earlier in this section, we can see a difference between the US Treasury rates and the corresponding swap rates.
The spread is generally positive, meaning market participants are seeking extra compensation for selling swaps as opposed to the corresponding government bond with the same maturity.
This is due to the fact that swaps are usually correlated with additional risks as opposed to bond trading. These include liquidity (i.e. how easy it is to get into and out of a position) as well as the credit quality of the banks that produce these goods. Since sovereign governments are usually perceived to be more creditworthy than commercial and investment banks, and the bond markets of the government are usually more liquid, the swaps are normally much riskier and generally trade at a small premium.
Yet due to liquidity considerations, macro prudential control, higher capital requirements, high Treasury debt dealer inventories, constraints on the balance sheets of dealers, and the trading operation of companies selling debt to the public, swap rates can actually be lower than the underlying bond.
Hedge funds and other traders will usually arbitrate the spread of a negative swap. But since the repo market, used to finance such trades, absorbs more capital for banks than has in the past (because of regulation) and margins have been squeezed in that business segment, hedge funds can no longer rely on repo funding to help facilitate this trade. Accordingly we continue to see the highest maturities of negative swap spreads.
How Do Traders Use Swaps?
They are less generally implemented at day-trading point, which in minutes or hours trades in and out of positions. Nevertheless, “day-trading” is a loosely used term. It may also include swing trading – which includes holding positions for several days or weeks.
A swap is an interest-rate. Interest is the credit price, or the loan fund price. (Side note: interest is not the price of money, as it is generally called. Money settles contracts, while credit is a promise of payment. They are essentially distinct sources of capital.)
If the inflation-adjusted interest rate – widely known as the real interest rate – varies between two countries, then traders are likely to bring more of their money into the country with higher returns.
This implies a strategy being implemented by certain traders is a strategy of spreading. For example, the inflation-adjusted interest rate on a 10-year US Treasury is currently around 0.8 percent (nominal yield of 3.1 percent minus inflation of 2.3 per cent). It is around minus-1.9 per cent on a German bund (0.4 per cent nominal yield minus inflation of 2.5 per cent). A trader may therefore be inclined to catch the spread of 270-base point (i.e., 2.70%).
These capital flows also affect demand for currency in one country versus the currency in another. As capital flows into USD properties, the value of the dollar increases, putting all else on equal footing. Similarly, the euro declines in value as capital moves away from euro-denominated properties, keeping all else equal, and so forth.
Remember this is no foolproof spread technique. Prices differ. This is, however, one usual strategy.
The Importance of Distinguishing Between Real and Nominal Interest Rates
The higher a country’s projected rate of inflation, the more compensation traders would demand keeping a specific commodity, such as a bond or currency.
Therefore it is important to differentiate between nominal yield and real yield when looking at bond and swap rates.
In the States, where inflation is about 2 per cent, a 3 per cent yield on the currency or a bond (a type of currency of longer duration) would generally mean a real yield of about 1 percent. In Turkey, where inflation is consistently high, the inflation rate could totally negate a 20 per cent yield on the currency or bond and could lead to negative real yield. Accordingly, while this is in place, traders can be inclined to buy up the US dollar over Turkish lira.
A simple trade theory follows that if inflation-adjusted interest rates in a given country decline, the currency is likely to decline along. Similarly, if a country’s real interest rates rise its currency is likely to rise in tandem.
The Shape of the Swap Curve
With economies going into their cycles later, yield curves begin to flatten. Many traders do a lot of this since an inverted yield curve – e.g., the 2-year yield is higher than the 10-year yield – will foresee a recession ahead.
Why? ‘Cause it shows that traders believe monetary policy has become too tight, and the central bank should take pressure off the economy’s debt-servicing burdens.
Looking at the USD swap curve we can see it’s flatter than the corresponding Treasury curve.
Some traders would put more weight on the value of this curve than on the corresponding Treasury curve because it represents banks’ credit quality, not just government credit.
In addition, some would put greater focus on the LIBOR curve than either the regular Treasury curve and its corresponding exchange rate curve. (The same applies to non-USD sovereign bonds) Provided that 84 percent of the U.S. corporate loan market is tied to LIBOR, this curve is widely used as the primary index for corporate loan and mortgage pricing and trading.
How Do You Make Money on Swaps?
The beneficiary of a swap’s fixed-rate component earns money when interest rates fall through the swap or yield curve more than is priced (and stay that way). It’s analogous to having a long chain. Prices rise as interest rates decrease.
The beneficiary of the portion of the fixed rate will lose money if interest rates rise above the price in the swap or yield curve (and remain higher than expected). At the other side of the deal the payer will make cash. This is equivalent to being a bond short. When interest rates go up, prices go down.
Risks of Investing in Interest Rate Swaps
All fixed income investments entail the same two prevailing risks – interest rate risk and credit risk.
The primary risk in sovereign debt derivatives was directly related to interest rates. This is the primary interest of all contracting parties.
As already stated, if interest rates fall the receiver will profit and if interest rates rise he will lose. The payer would benefit from rising interest rates, and lose if interest rates fall. Since the interest rates are continuously fluctuating, interest rate risk will still be involved.
The credit risk refers to a default on the contract by the bank or financial institution. This is widely referred to as counterparty risk, too. Credit risk may also mean the government’s likelihood of defaulting on its debt. This is unlikely to be completely out of the question for countries like the US and other high credit-rating nations, given the popular misconception that this debt is “risk-free.” Swaps are more of an instrument of default risk than the underlying sovereign bond.
How To Trade Interest Rate Swaps
As a day trader (or trader of any kind), the use of interest rate swaps for “speculation” purposes, or betting on market change, will be considered.
Some traders tend to buy swaps due to the embedded leverage inherent in the swap contract, rather than the underlying instruments. For eg, a 2-year deliverable interest rate swap futures (i.e., a 2-year Treasury bond swap contract, denominated in USD) that goes by the ECBOT exchange symbol T1U, the leverage ratio could be about 200 to 1. The margin of intraday and of overnight is normally different.
The intraday maintenance margin is roughly $500 for each contract, which is usually worth about $100,000 per contract (depending on the price you purchased).
The more uncertainty the underlying bond inheres, the higher the margin criteria.
For instance, when trading fed fund futures, the embedded leverage can be about 2,000 to 1 or higher, providing about $400,000 per contract and a maintenance margin of $100-$200 depending on whether it is kept intraday or overnight.
The related swap contract N1U would have embedded roughly 50x to 60x margin on long-term underlying bonds, such as the 10-year US Treasury.
Other Reasons for Owning Interest Rate Swaps
Some traders use interest rate swaps to protect against exposure to interest rates or express views in various ways on the credit market.
Traders with good credit quality, long term bonds, for example, may want to offset this risk by using swaps. Essentially, the swaps are used mainly as an insurance type.
Shape of the Yield Curve
Some make a bet on the potential form of the yield curve using swaps. For example, traders who think the yield curve is too steep may sell the front end of the curve (expecting increases in rates), buy the back end of the curve (expecting down rates), or both.
Other Credit Securities are Unavailable or Unviable to Trade
Swaps for other fixed income securities may be used as proxy. Many markets for the fixed income are fairly illiquid. This is also partly why bonds and other fixed-income securities are less common among day traders as opposed to equities, currencies and commodities. Swaps are often also more liquid markets for specific underlying securities.
Resolve Asset and Liability Mismatches
Their liabilities are mostly short-term in nature for banks and insurance firms, while their assets (i.e., mostly loans) are longer term. If these do not suit, and liabilities are due without adequate assets to support them, this may create a solvency problem. Such agencies can help balance the length of the assets with the length of the liabilities to better control the assets and liabilities.
Lock in Financing Long-Term
When companies issue bonds, they will also try to lock in the rate by signing swap agreements. They will sell those swaps until they are able to sell these bonds to the buying public. This helps to guard against any possible increased cost of financing. The swap contracts would help neutralize this loss in the event interest rates go up in the time it took to sell the bonds.
Align Interest Rate Movements with Their Asset Mix or Business Interests
Some businesses benefit from rising interest rates – for example, some banks, insurance firms, investment managers. On the other hand, specific others benefit from declining interest rates, such as homebuilders, developers of real estate, growers, and other organizations dependent on lower borrowing costs.
Some companies will opt to pay the floating rate and have earned the fixed rate to protect against dropping interest rates. Others can opt to obtain the floating rate to hedge against rising interest rates and pay the fixed rate.
Offset Net Interest Rate Exposure
Banks have balance sheets containing vast amounts of loans, savings and derivatives contracts that can result in some exposure to net interest rate. Based on the combination of fixed rate and floating rate assets and liabilities, both of these will balance each other and their durations. A risk management department of a bank must keep track on the mix. Any net unfavorable exposure to interest rates can be offset with interest rate swap deals.
Trading interest rate swaps is not as common as trading equities, currencies, and commodities. Part of it is the most brokers have restricted access. (Certain brokers open to individual investors, such as Interactive Brokers, are an exception.) Perhaps part of this is that interest rate derivatives are not as easily known by the public to the same degree as the asset groups that dominate the financial media reporting.
Mechanically, interest rate derivatives are quite similar to a bond. Many with fixed-rate exposure – the buyer of a fixed-rate bond in normal cases – can benefit when interest rates fall, and lose money when interest rates rise. All who enter a swap with floating rate exposures — normally the one who shortsell a fixed rate bond — will benefit as interest rates rise and lose money as interest rates drop.
Since the former are often more liquid, many traders tend to use swaps over bonds. In addition, swaps usually require only a small initial outlay of capital, which may magnify both returns and loss.
Day traders and other investors will use them to bet on up and down moves or a rise in one rate versus another for trading purposes. But they may also represent other companies as a core function, such as hedging, risk management and other corporate finance needs.