Interest Rate Derivative Market

Rashedul Hasan

swap

• In finance, a swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap.

• Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

An interest rate swap

An interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. In most common cases, fixed rate interest payments are exchanged for floating rate interest rate payment over time. The provisions of an interest rate swap include,

interest rate swap

• The notional principal value to which the interest rates are applied to determine the interest payment

• The fixed interest rate• The foemula and Type of index used to determine

the floating rate• The frequency of payments, such as every 3

months, 6 months etc.• The lifetime of the swap.

interest rate swap• For example, Financial institutions such commercial

banks in U.S. traditional had more interest rate sensitive liabilities than assetsa and therefore can adversily affected by increasing interest rate. On the other hand, some financal institutions in Europe, had funds primarily for floaing-rate loan. These institutions are adversly affected by declining interest rate.

• By engaging in interest rate swap, both type of financial institutions could reduce their their expouser to inteest rate risk. The U.S. financial institutions could send fixed rate interest payments to a European financial institution in exchange for floating

rate payments.

interest rate swap

Although, U.S. financial institutions foregoes the potential benefits from decline in interest rate, while the European financial institutions foregoes the potential benefits from increase in interest rate. The interest rate swap enables each institutions to offset any gains or losses that result specifically

from interest rate movement.

Swap marketThe first swaps were negotiated in the early 1980s. David Swensen, a Yale Ph.D. at Salomon Brothers, engineered the first swap transaction according to "When Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein. Today, swaps are among the most heavily traded financial contracts in the world.

Swap marketMost swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Swap is less standardized than other derivative instruments such as Future or Option. Therefore, Telecommunication network is more prefarrable than a physical exchange for the swap trade. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG.

Types of Interest Rate SWAP

• Plain Vanilla swapIt is also known as fixed-for-floating swap. Here fixed rate payments are periodically exchanged for floating rate payments.

• Forward swapIt involves an exchange of interest payments that does not begin until a specified future point of time. It is useful for firms, that expect to exposed to interest rate risk at a future point in time.

Types of Interest Rate SWAP

• Callable swap

It provides the party making the fixed payments with the right to terminate the swap prior to its maturity.

• Putable swap

It allows the party making the floating rate payments with the right to terminate the swap prior to its maturity.

• Extendable swap

It allows the fixed-for-floating party to extend the swap

period.

Types of Interest Rate SWAP

Zero coupons for floating swap

Here the fixed rate payer makes a single payment at the maturity date of the swap agreement, while the floating rate payer makes periodic payments throughout the swap period.  

Interest rate Caps, Floor & Collars

• Interest rate CapsAn Interest rate Cap offers payment when a specified interest rate index exceeds the interest rate ceiling (cap) and therefore can hedge against rising interest rate. The lifetime of a cap is commonly between 3 to 8 years. The typical buyer of an interest rate cap is the financial institution that is adversely affected by rising interest rate. If interest rate rise the payment received from the interest rate cap agreement will help offset any adverse affect. The seller of the interest rate cap receives the fee paid up-front.

Interest rate Caps, Floor & Collars

• Interest rate FloorAn Interest rate Floor offers payment when a specified interest rate index falls bellow the specified interest rate floor. They can be used to hedge against declining interest rate.

Interest rate Caps, Floor & Collars

• Interest rate Collars

An Interest rate Collar involves the purchase of an interest rate cap and the simultaneous sale of interest rate floor. In its simplest form, the fees received up-front from selling the interest rate floor to one party can be used to pay the fees for purchasing the interest rate cap from another party. Any financial institution that desires to hedge against the possibility of rising interest rate can

buy an Interest rate Collar.

Financial institutions Participation in SWAP market

Commercial Banks •Engage in swaps to reduce interest rate risk

•Serve as an intermediary by matching up two parties in swap

Serve as a dealer by taking the counter party position to accommodate a party that desires to engage in swap.

Savings Institutions, Loan associations and Savings Bank

Engage in swaps to reduce interest rate risk

Finance Company Engage in swaps to reduce interest rate risk

Securities firms •Serve as an intermediary by matching up two parties in swap

Serve as a dealer by taking the counter party position to accommodate a party that desires to engage in swap.

Insurance company Engage in swaps to reduce interest rate risk

Pension funds Engage in swaps to reduce interest rate risk