The basic structure of an interest rate swap consists of the exchange between two counter-parties of fixed rate interest or floating rate interest in the same currency calculated by reference to a mutually agreed notional principal amount. This principal amount, which would normally equate to the underlying assets or liabilities being “swapped” by the counter-parties, is applicable solely for the calculation of the interest to be exchanged under the swap. At no time it is physically passed between the counter-parties. The counter-parties are able to convert an underlying fixed rate asset/ liability and vice-versa, through this straight forward swap structure. The majority of the interest rate swap transactions are driven by the cost savings to be obtained by each of the counter-parties. These cost savings are substantial and result from differentials in the credit standing of the counter-parties and other structural considerations.
Generally investors in fixed rate instruments are more sensitive to credit quality than floating rate bank lenders. Accordingly a greater premium is demanded of issuers of lesser credit quality in the fixed rate debt markets than in the floating rate bank lending market. The counter-parties to an interest rate swap may therefore obtain an arbitrage advantage by accessing the market in which they have the greatest relative cost advantage and then entering into an interest rate swap to convert the cost of the funds so raised from a fixed rate to a floating rate basis or vice-versa.
This ability to transfer a fixed rate cost advantage to floating rate liabilities has led to many high quality credits issuing fixed rate Eurobonds purely to “swap” and obtain , in many cases, sub-LIBOR funding. The use of this structure in a fixed fate Eurobond issue enables the issuer to obtain substantial funding at points below London Interbank Offered Rate (LIBOR). This most attractive of rates is made possible by (i) the careful timing of the Eurobond issue to ensure its success at the finest of rates and (ii) the use of exact hedging and a deferred swap accrual date to ensure the best possible swap terms for the issuer. The counter-party to the swap may be a combination of banks and corporate clients. The banks may want to hedge their fixed rate income into a floating rate return that fully matched their floating rate liabilities in order to alleviate interest rate exposure. The corporate clients may want to hedge their floating rate binding into fixed rate liabilities for a size and maturity unavailable in the direct fixed rate debt market. Acting as principal, the intermediary may be able to provide both the banks and its corporate clients with swap terms to meet their exact requirements and then subsequently lock the Eurobond issuer into an opposite swap when the Eurobond market was most receptive to the issue. Interest rate swaps also provide an excellent mechanism for entities to effectively access markets which are otherwise closed to them. The ability to obtain the benefits of markets without the need to comply with the prospectus disclosures, credit ratings and other formal requirements and other formal requirements provides an additional benefit especially for private companies. An excellent example of the swap market’s flexibility in providing benefits is the growth of interest rate swaps using commercial paper as the underlying floating rate basis. The interest rate swap market also provides finance money with the perfect mechanism for managing interest rate costs and exposure whilst leaving the underlying source of funds unaffected. For example, the cost of fixed rate funding may be reduced in a declining interest rate environment through the use of the interest rate swap technique whilst leaving the underlying funding in place.
After a close observation of the interest rate swap market it is experienced that it possess certain characteristics of a fairly well-organized financial market. There are a larger number of players with fairly distinct roles in the market, there are several different structures of the market in which certain players specialize. There is both a primary and a secondary market in interest rate swaps. Not only this, there is sufficient liquidity in both the primary and secondary markets of certain sectors such that a few players do trade or make markets in interest rate swaps and in even fewer cases have significant capital commitments to the swap market. After the above explanation, we are in a position to say that swap market activities can be classified into two sectors:
- The primary market and,
- The secondary market.
The Primary interest rate swap market has the further divisions like –source of raw material for a interest rate swap-bank, financial market funding, hedging instruments and the securities markets. European bond market can be taken as an example. The primary sector can be distinguished by the activities like maturity and type of player. The short term sector of the primary market is essentially an inter bank market dominated by the funding and hedging activities of both large and small banks. The banks are both providers and takers in the segment of the market depending on the structure of their asset base. Since it is extremely volatile in price in terms of spread, the market-making or position taking is, therefore only for the most experienced dealers. For such dealers profit potential is high and risks in position–taking while similarly high, are manageable due to impressive array of instruments available to manage risks. New York is the center of this market with London and Tokyo following it. The main participants are the banks which include a number of brokers who have extended their normal money market dealing activities with banks to include interest swap activities. Success in this segment of the primary market does not depend only on close integration of an institution’s treasury and swap operations, but also on distribution and in particular, the ability to move positions quickly due to the price volatility and risks inherent to the market. Inventory also quickly becomes stale in the short-term market because most transactions are done on a ‘spot’ basis holding a position for a period of time may therefore mean one’s inventory may not move irrespective of price. However, the growth of the secondary market in the short term swaps has decreased the risks of position – taking in the short term secondary market. The use of financial futures has been the special feature of the secondary market which create ‘the other side’ of an interest swap. While financial futures-based swaps are highly complex to execute properly, the very quick and sharp movements in this market and hence, the need to “wind and un-wind” these structures to maximize profits has increased the liquidity in the secondary market.
Excepting the yield, the primary interest rate swap market is dominated by securities transactions and particularly the Eurodollar bond market. This market segment is very large. It is estimated that some 75% of all Eurodollar bond issue are swapped and the dollar fixed –rate Eurobond market is currently running at an annual rate of $50 billions plus. The Eurodollar bond market never closes due to interest rate levels. Issuers who would not come to market because of high interest rates now do so to the extent that a swap is available. The firms that now dominate lead management roles in the Eurodollar bond market all have substantial swap capabilities and this trend will continue. Pricing in this segment of the market is exclusively related to the U.S. Treasury rates for comparable maturities and is marked by the relative stability of these spreads by comparison to the short-term market. The size of the Eurobond issues and the oversupply of entities able and willing to approach the Eurobond market to swap into floating rate funds, most major houses in the swap market now enter into swap agreements with an issuer without counter-party, on the other side.