Common use of Interest Rate Swaps Clause in Contracts

Interest Rate Swaps. A swap is a contractual agreement between two parties to exchange, or “swap,” future payment streams based on differences in the returns to different securities or changes in the price of some underlying item. Interest rate swaps constitute the most common type of swap agreement. In an interest rate swap, the parties to the agreement, termed the swap counterparties, agree to exchange payments 2000 1400 1200 Billions of Dollars 1000 800 600 400 200 0 Year-End 1985 1986 1987 1988 1989 1990 1991 Source: Market Survey Highlights, Year End 1991, International Swap Dealers Association, Inc. indexed to two different interest rates. Total payments are determined by the specified notional principal amount of the swap, which is never actually ex- changed. Financial intermediaries, such as banks, pension funds, and insurance companies, as well as nonfinancial firms use interest rate swaps to effectively change the maturity of outstanding debt or that of an interest-bearing asset.1 Swaps grew out of parallel loan agreements in which firms exchanged loans denominated in different currencies. Although some swaps were arranged in the late 1970s, the first widely publicized swap took place in 1981 when IBM and the World Bank agreed to exchange interest payments on debt de- nominated in different currencies, an arrangement known as a currency swap. The first interest rate swap was a 1982 agreement in which the Student Loan Marketing Association (▇▇▇▇▇▇ ▇▇▇) swapped the interest payments on an issue of intermediate-term, fixed-rate debt for floating-rate payments indexed to the three-month Treasury bill yield. The interest rate swap market has grown rapidly since then. Figure 1 displays the year-end total notional principal of U.S. dollar 1 See Wall and ▇▇▇▇▇▇▇ (1988) for a more comprehensive survey of market participants. interest rate swaps outstanding from 1985 to 1991. Based on market survey data published by the International Swap Dealers Association (ISDA), U.S. dollar in- terest rate swaps comprise about one-half of all interest rate swaps outstanding: the notional principal amount of U.S. dollar interest rate swaps outstanding as of the end of 1991 was just over $1.5 trillion, compared to almost $3.1 trillion for all interest rate swaps. Early interest rate swaps were brokered transactions in which financial in- termediaries with customers interested in entering into a swap would seek counterparties for the transaction among their other customers. The intermedi- ary collected a brokerage fee as compensation, but did not maintain a continuing role once the transaction was completed. The contract was between the two ultimate swap users, who exchanged payments directly. Today the market has evolved into more of a dealer market dominated by large international commercial and investment banks. Dealers act as market makers that stand ready to become a counterparty to different swap transactions before a customer for the other side of the transaction is located. A swap dealer intermediates cash flows between different customers, or “end users,” becoming a middleman to each transaction. The dealer market structure relieves end users from the need to monitor the financial condition of many different swap coun- terparties. Because dealers act as middlemen, end users need only be concerned with the financial condition of the dealer, and not with the creditworthiness of the other ultimate end user of the instrument (▇▇▇▇▇ and ▇▇▇▇▇ 1990). Figure 2 illustrates the flow of payments between two swap end users through a swap dealer. Unlike brokers, dealers in the over-the-counter market do not charge a commission. Instead, they quote two-way “bid” and “asked” prices at which they stand ready to act as counterparty to their customers in a derivative instrument. The quoted spread between bid and asked prices allows an intermediary to receive a higher payment from one counterparty than is paid to the other. FIXED PAYMENTS (ask rate) DEALER FIXED PAYMENTS (bid rate) FLOATING PAYMENTS FLOATING PAYMENTS There are many different variants of interest rate swaps. The most common is the fixed/floating swap in which a fixed-rate payer makes payments based on a long-term interest rate to a floating-rate payer, who, in turn, makes payments in- dexed to a short-term money market rate to the fixed-rate payer. A fixed/floating swap is characterized by: – a fixed interest rate; – a variable or floating interest rate which is periodically reset; – a notional principal amount upon which total interest payments are based; and – the term of the agreement, including a schedule of interest rate reset dates (that is, dates when the value of the interest rate used to determine floating-rate payments is determined) and payment dates. The fixed interest rate typically is based on the prevailing market interest rate for Treasury securities with a maturity corresponding to the term of the swap agreement. The floating rate is most often indexed to three- or six-month LI- BOR, in which case the swap is termed a “generic” or “plain vanilla” swap, but can be indexed to almost any money market rate such as the Treasury bill, commercial paper, federal funds, or prime interest rate. The maturity, or “tenor,” of a fixed/floating interest rate swap can vary between 1 and 15 years. By convention, a fixed-rate payer is designated as the buyer and is said to be long the swap, while the floating-rate payer is the seller and is characterized as short the swap.