Understanding Interest Rate Swaps

At the time of the swap agreement, the total value of the swap’s fixed rate flows will be equal to the value of expected floating rate payments implied by the forward SOFR curve. As forward expectations for SOFR change, so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted in this fixed rate, or alternatively in the “swap spread,” which is the difference between the swap rate and the equivalent local government bond yield for the same maturity.

A similar principle applies when looking at money itself and considering interest as the price for money. If the real return (adjusted for inflation) on a financial asset differs between two countries, investors will flock to the country with the higher returns. Interest rates have to change to stop this movement. The theory behind this relationship is called the interest rate parity theory. (When looking at interest rates, it is important to distinguish between real rates and nominal rates, with the difference reflecting the rate of inflation. The higher the expected inflation in a country, the more compensation investors will demand when investing in a particular currency.)

What is the swap curve?

The plot of swap rates across all available maturities is known as the swap curve, as shown in the chart below. Because swap rates incorporate a snapshot of the forward expectations for SOFR, as well as the market’s perception of other factors such as liquidity, supply and demand dynamics, and the credit quality of the banks, the swap curve is an extremely important interest rate benchmark.

Although the swap curve is typically similar in shape to the equivalent sovereign yield curve, swaps can trade higher or lower than sovereign yields with corresponding maturities. The difference between the two is the “swap spread”, which is shown in the chart below. Historically the spread tended to be positive across maturities, reflecting the higher credit risk of banks versus sovereigns. However, other factors, including liquidity, and supply and demand dynamics, mean that in the U.S. today the swap spread is negative at longer maturities.

Because the swap curve reflects both SOFR expectations and bank credit, it is a powerful indicator of conditions in the fixed income markets. In certain cases, the swap curve has supplanted the Treasury curve as the primary benchmark for pricing and trading corporate bonds, loans and mortgages.

How does a swap contract work?

At the time a swap contract is put into place, it is typically considered “at the money,” meaning that the total value of fixed interest rate cash flows over the life of the swap is exactly equal to the expected value of floating interest rate cash flows. In the example below, an investor has elected to receive fixed in a swap contract. If the forward SOFR curve, or floating-rate curve, is correct, the 2.5% he receives will initially be better than the current floating 1% SOFR rate, but after some time, his fixed 2.5% will be lower than the floating rate. At the inception of the swap, the “net present value,” or sum of expected profits and losses, should add up to zero.

However, the forward SOFR curve changes constantly. Over time, as interest rates implied by the curve change and as credit spreads fluctuate, the balance between the green zone and the blue zone will shift. If interest rates fall or stay lower than expected, the “receiver” of fixed will profit (green area will expand relative to blue). If rates rise and hold higher than expected, the “receiver” will lose (blue expands relative to green).

If a swap becomes unprofitable or if a counterparty wishes to shed the interest rate risk of the swap that counterparty can set up a countervailing swap – essentially a mirror image of the original swap – with a different counterparty to “cancel out” the impact of the original swap.

How to invest in interest rates swaps?

Interest rate swaps became an essential tool for many types of investors, as well as corporate treasurers, risk managers and banks, because they have so many potential uses. These include:

• Portfolio management. Interest rate swaps allow portfolio managers to adjust interest rate exposure and offset the risks posed by interest rate volatility. By increasing or decreasing interest rate exposure in various parts of the yield curve using swaps, managers can either ramp-up or neutralize their exposure to changes in the shape of the curve, and can also express views on credit spreads. Swaps can also act as substitutes for other, less liquid fixed income instruments. Moreover, long-dated interest rate swaps can increase the duration of a portfolio, making them an effective tool in Liability Driven Investing, where managers aim to match the duration of assets with that of long-term liabilities.
• Speculation. Because swaps require little capital up front, they give fixed income traders a way to speculate on movements in interest rates while potentially avoiding the cost of long and short positions in Treasuries. For example, to speculate that five-year rates will fall using cash in the Treasury market, a trader must invest cash or borrowed capital to buy a five-year Treasury note. Instead, the trader could “receive” fixed in a five-year swap transaction, which offers a similar speculative bet on falling rates, but does not require significant capital up front.
• Corporate finance. Firms with floating rate liabilities, such as loans linked to LIBOR, can enter into swaps where they pay fixed and receive floating, as noted earlier. Companies might also set up swaps to pay floating and receive fixed as a hedge against falling interest rates, or if floating rates more closely match their assets or income stream.
• Risk management. Banks and other financial institutions are involved in a huge number of transactions involving loans, derivatives contracts and other investments. The bulk of fixed and floating interest rate exposures typically cancel each other out, but any remaining interest rate risk can be offset with interest rate swaps.
• Rate-locks on bond issuance. When corporations decide to issue fixed-rate bonds, they usually lock in the current interest rate by entering into swap contracts. That gives them time to go out and find investors for the bonds. Once they actually sell the bonds, they exit the swap contracts. If rates have gone up since the decision to sell bonds, the swap contracts will be worth more, offsetting the increased financing cost.

What are the risks?

Like most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk.

Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk. Put simply, a receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer (the counterparty paying fixed) profits if rates rise and loses if rates fall.

Swaps are also subject to the counterparty’s credit risk: the chance that the other party in the contract will default on its responsibility. This risk has been partially mitigated since the financial crisis, with a large portion of swap contacts now clearing through central counterparties (CCPs). However, the risk is still higher than that of investing in a “risk-free” U.S. Treasury bond.