What is a Swaps Dealer?
A swaps dealer is an entity or individual involved in market-making activities in swaps, or who enters into swap contracts with counterparties or serves as a swaps broker. The function was largely unregulated prior to the global financial crisis, with transactions commonly executed between companies and financial institutions. However, in 2011 the Securities and Exchange Commission (the financial regulator in the US known as the SEC) introduced proposals that would require securities-based swap dealers and participants to register with the commission.
Key Learning Points
- Interest rate swaps are derivative contracts between two counterparties who enter into an agreement to exchange fixed and floating-rate payments.
- The swap curve, which reflects both LIBOR expectations and bank credit, is considered a powerful indicator of conditions in the fixed-income markets.
- An interest rate swaps dealer is an individual or legal entity that facilitates transactions in swap contracts and may act as an agent (a broker) or a principal.
- The most common type of interest rate swap is where a fixed rate payment is exchanged for a variable (floating) rate payment, but there are also other contracts that may facilitate the exchange of two floating-rate streams.
What is an Interest Rate Swap?
Swaps are derivative instruments that trade over-the-counter (OTC). An interest rate swap is a two-party agreement to exchange one stream of interest payments for another over a specified timeframe. The most popular contracts are known as “vanilla” swaps and involve the exchange of fixed-rate payments for floating-rate payments based on the London Interbank Offered Rate (LIBOR, the daily established interest rate that banks charge one another for short-term lending). There are also other types of interest rate swaps that exchange fixed to fixed rate, or one floating rate for another, called “basis swaps,” but the “vanilla” swap represents the vast majority of trades.
How do Interest Rate Swaps Work?
Most commonly, swap market makers are high-credit quality investment and commercial banks that offer both fixed and floating-rate cash flows to their clients. A typical swap transaction is between a client who may be an investor or a bank on one side, and an investment or commercial bank on the other. Following the execution of the transaction, the bank would normally offset the swap through an inter-dealer broker and charge a commission for setting up the original swap. Should the transaction size be large, the inter-dealer broker could arrange to sell it to a number of different counterparties. Normally, at the time a swap contract is put into place, it is considered “at the money.” This means 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.
Interest Rate Swaps Example
Let’s assume that an investor enters into an agreement to receive a fixed-rate payment. The agreed rate is 2% and the current LIBOR rate is 1%. Initially, the investor might be better off but after some time, the fixed rate may fall beneath the floating rate. At the inception of the swap, the “net present value,” or the sum of expected profits and losses, should add up to zero. However, LIBOR rates change constantly, and should interest rates fall or remain lower than expected, the receiver of the fixed payment will profit. If rates rise and remain higher than expected, the receiver will experience a loss. In that case, the counterparty can “cancel out” the effect of the original swap by setting up a countervailing swap with a different counterparty, which would mirror the original swap.
Access the free download to see a mapped example of an interest rate swap.
Why Are Interest Rate Swaps Used?
Typically, interest rate swaps help corporations manage their floating-rate liabilities by allowing them to pay fixed rates, and receive floating-rate payments. This allows them to enter a contract where they will pay the prevailing fixed rate and will receive payments that match their floating-rate debt. As swaps reflect the market’s forward-looking view on interest rates, swaps also became an attractive tool for other fixed-income investors.
What is a Swap Rate?
The fixed interest rate that the receiver demands to compensate for the uncertainty of having to pay the short-term variable rate (LIBOR) over time is called the “swap rate.” Swap rates can be applied to different types of swaps. As the market’s expectations for the future LIBOR rate are reflected in the forward-looking LIBOR curve, when the agreement is made the total value of the swap’s fixed rate flows should equal the value of expected floating rate payments. In that case, the fixed rate that investors demand to enter into a new agreement will change in line with the LIBOR rate.
Advantages and Disadvantages of Interest Rate Swaps
Interest rate swaps are essential instruments for almost any type of institutional investor as they have a variety of applications. For example, in portfolio management swaps help manage interest rate exposure and offset the risks of interest rate moves. Investment and commercial banks also use interest rate swaps as a risk management tool since their businesses involve a high volume of loans, derivatives, and other investments. While the majority of fixed and variable interest rate exposures would typically cancel each other out, the remaining interest rate risk can be offset using interest rate swaps.
On the other hand, interest rate movements are not always consistent with expectations, and therefore swaps also entail interest-rate risk. This means that the receiver of the fixed-rate payment would profit if interest rates fall, while the payer would profit if rates rise and vice versa. Counterparty risk (also referred to as “credit risk”) is another aspect of interest rate swaps. It entails the risk that one party to the agreement could default on its contractual obligations. Although this risk has been mitigated to a certain degree following the global financial crisis with many of the swap contracts clearing through central counterparties, it is still higher relative to investing in low-risk assets such as US government bonds.
Explore and practice interest rate swaps further, as well as other fixed income derivatives including swaps and credit default swaps (CDS), in our online FICC trader course