Interest rate swaps have become an important tool for asset/liability managers to reduce overall sensitivity to changes in interest rates. Swaps are also increasingly used by bank corporate customers. According to Salomon Brothers, money center bank swap activity peaked in 1990, but current levels of outstanding swaps continue to climb.(1)
One reason for the high level of interest rate swap activity in 1990 was the large number of highly leveraged transactions (HLTs). The debt levels that highly leveraged companies experienced forced them to protect themselves or to "hedge" against a rise in rates, since a rise in rates could have put some of them out of business.
The need for bank liquidity in 1991 and 1992 also increased the number of interest rate swaps. The need for liquidity was driven by the deteriorating real estate environment in the Northeast and Mid-Atlantic regions. According to Salomon Brothers, between 1987 and 1991, superregional banks increased their use of interest rate swaps by 550%. Regional banks increased their use by 245%. However, the use of interest rate swaps by regional banks is still low compared with the money center banks that continue to dominate the market. See Figure 1 for more information on recent swap activity by the various types of banks.
For the most part, the difference in the volume of interest rate swaps between money center banks and superregional banks can be explained by the fact that money center banks act as brokers for interest rate swaps, while superregionals generally use swaps only as hedging tools.
A Definition of Interest Rate Swaps
An interest rate swap is a contractual agreement, evidenced by a master document, in which two parties, called counterparties, agree to exchange interest rate payments. Swap agreements, or swap confirmations as they are sometimes called, are fairly standardized and contain the following information:
* The currencies to be exchanged.
* The rate of interest--which may be fixed or floating.
* The dates when payments will be made.
* Any other provisions that may influence the transaction.
The most common type of interest rate swap is a fixed-for-floating arrangement. This is what is sometimes described as a "plain vanilla" swap. In this type of swap, the customer agrees to make fixed-rate payments to the bank in exchange for receiving floating-rate interest payments. Figure 2 shows how this type of swap works.
The fixed rate of interest in a fixed-for-floating rate swap is called the swap coupon. The interest payments are calculated on the basis of a hypothetical amount of principal called the notional amount. The notional amount represents the dollar amount assigned to a contract on which the interest payments are calculated. There is no principal exchanged; only the interest payments are exchanged. See the glossary beginning on page 20 for definitions of other words commonly used in swap agreements.
A Typical Structure
When a bank enters into a fixed-for-floating swap, the bank receives a fixed swap coupon of, say, 6% and agrees to pay a floating London interbank offered rate (LIBOR) of, perhaps, 3% on a notional swap of $10 million. If this is the case, the bank would receive a net interest payment of 3% for the first three-month period.(2)
Why Are Swaps Used?
Banks are turning to swaps for several reasons:
1. Swaps tend to trade at a higher yield than Treasury securities. This reflects the difference between a U.S. Government risk and a corporate risk. In effect, swaps perform more like corporate bonds.
2. Interest rate swaps are off-balance-sheet instruments and require less capital than cash investments.
3. There are some positive accounting treatments for swap transactions. Often, gains and losses on swaps that are categorized as hedges can be deferred over the life of the instrument being hedged. …