Swaps, in simplest terms is a contract where the counterparties exchange one cash flow to another. The differences in the cash flows are
1) the rate at which each cash flow is calculated;
2) How often the cash flow is exchanged;
3) if a floating rate is used for the cash flow, how often the floating rate will reset;
4) the day count convention to apply when calculating the cash flow
Who are the primary Interest Rate Swap Market Participants?
Interest rate swaps are used by
Unleveraged Buyers of Assets (Investors, Pension Funds, Mutual Funds)
Why do market participants use swaps?
In the Interest Rate Swap Market the concept of Comparative Market Advantage is useful to understanding why each market participant uses swaps.
Let’s take each counterparty in turn.
Corporations: Borrowers of money; Swaps give corporations the ability to separate where they borrow from and how they manage their interest rate risk
Higher Credit Rating: If Corporation borrows in the public bond market (fixed rates typically) at a lower rate than they would pay to a bank on a bank loan, they will issue a bond and pay a fixed coupon to bondholders.
If a Higher Rated Corporation wants to pay fixed and it fits their asset-liability management, their fixed-floating mix and cash flow then they will remain in a fixed rate liability.
If a Higher Rated Corporation would prefer to pay a floating rate, they will enter into an interest rate swap to RECEIVE FIXED AND PAY LIBOR.
Lower Credit Rating: If Corporation borrows from a bank (floating rate loan) at a lower rate than the public would lend them money, they will take out a bank loan and pay LIBOR plus a spread.
If a Lower Rated Corporation wants to pay LIBOR and the bank loan fits their asset-liability, fixed-floating and cash flow mix, they will remain in a bank loan.
If a Lower Rated Corporation would prefer to pay a fixed rate, they will enter into an interest rate swap to PAY FIXED AND RECEIVE LIBOR
Asset Managers: Lenders of money; Unleveraged buyers of assets. Swaps give Asset Managers the ability to separate their investment decision and tyheir risk management decision; The asset manager will invest where yields are highest and manage their interest rate risk as they wish.
One of the more common ways asset managers use interest rate swaps is to buy a fixed rate note or bond and enter into a swap to PAY FIXED AND RECEIVE LIBOR. The end restul is the assetmanager receives LIBOR plus a spread.
The asset manager can purchase the bond and enter into the swap on their own:
But most asset swaps today trade as a package. the Swap dealer buys the asset, enters into a swap and puts the asset swap into an SPV. The Asset Manager pays par (100%) and receives a regular coupon at LIBOR plus a spread:
Hedge Funds: Leveraged funds view swaps as synthetic bond positions. Specifically, a bond that has been financed or repo’d. First we will look at the similarities and then discuss the differences between the two approaches.
Looking just at the couopn flows, the position is receiving the fixed coupon on the bond and paying the repo rate on the financing of the bond position.
The above is economically similar to an interest rate swap to RECEIVE FIXED and PAY LIBOR.
If a leveraged fund wanted to get short a bond. They could short the bond, and borrow it in repo (to deliver it to the buyer).
To isolate just the coupon flows the position is paying the fixed coupon on the bond and receiving the short term repo rate.
The above is economically similar to entering into a swap to PAY FIXED AND RECEIVE LIBOR.
The differences between the bond position and the swap position are:
1) Credit rating of the bond position would be subject to whatever the credit rating of the issuing corporation (or sovereign entity) is.
2) Credit rating of the swapis counterparty credit risk, which is mitigated by posting initial collateral on the swap as well as paying losses and receiving profits daily.
3) the floating leg on the swap is 3 Month LIBOR; the bond is financed at the repo rate, which is typically an overnight rate. The spread between 3 ML and Repo is fairly stable unless the bond is hard to borrow (“special”).