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Derivatives
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Stock Options
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Stock Warrants
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Interest Rate Swaps
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Interest Rate Caps, Floors
and Collars
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Swaptions
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Futures and Forward
Contracts
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Managed Futures
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Interest Rate Swaps
The American Heritage
dictionary defines a SWAP as an exchange. An interest rate swap is a
contract between two counterparties to exchange the interest payments on a
notional amount of principal balances from floating rates to fixed rates and
vice versa. The notional principal balance is normally the weighted average
outstanding during the period.
Don’t overthink the
concept. Procedurally, all one does is calculate the interest amount under
both scenarios, net the amounts together, and settle with the bank.
Example:
There were several midsize leasing companies in the northeast that
specialized in multimedia equipment, and relied on interest rate swaps to
match fund their loan portfolios. They leased digital multimedia equipment,
costing several hundred thousand dollars each, to the post production houses
and film studios. Their business models were such that most of their leases
were written on fixed rate, 5 year paper, with a $1 residual purchase
option. Initially, the leases were funded by floating rate warehouse lines.
Semimonthly the leases were securitized. During the securitization process,
floating rate debt was swapped for fixed rate debt. This way, the profit on
the month’s book of business was locked in; it quantified with certainty the
amount of future obligations for these companies.
Interest rate swaps are
an added value tool for most businesses. Let’s go over another example.
Assume you’re working for a manufacturing company that has outstanding debt
under a floating rate revolving loan. Also assume that rates are low and
there’s a general feeling that they are going to increase. Going back to
the lenders to refinance the existing floating rate loan into a fixed rate
loan is time consuming and expensive. It’s more practical just to enter into
a swap agreement to exchange interest rates. The effect is the same as a
refinancing; you are locking into lower fixed rate net interest payments.
It’s a nice way to lower funding cost and take advantage of current and
projected market conditions.
Here’s the
issue: for a modest premium, you can control a large notional amount. The
examples above used swaps as a hedge with a true economic use. Now suppose
you don’t control any notional offsetting balances and you enter into a
speculative swap agreement, betting on the future direction of the yield
curve. If you bet correctly it can be extremely profitable, but if you bet
wrong, it can be disastrous. Timing interest rates can be frustrating.
During 2004-2005, the Federal Reserve had been increasing short-term
interest rates, only to discover that the markets decreased long-term rates.
The government was trying to increase rates to keep inflation under control
and to prevent a bubble in the real estate market, yet the markets were
lowering long-term rates that were propping up real estate prices. It goes
to show how difficult it is to correctly predict interest rate movements.
Sometimes it’s a conundrum. The leverage and risk on unhedged swaps is huge;
it can be very costly if you bet incorrectly!
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