Suppose that you own a house with a fixed rate mortgage and your neighbor has a floating rate mortgage. Due to economic circumstances, you'd like to move to a floating rate mortgage and your neighbor would like to pay a fixed rate. Instead of refinancing or assuming the others' mortgage, you make an agreement with your neighbor whereby they will pay you your fixed rate and you'll pay them a floating rate indexed to the LIBOR rate (e.g. LIBOR + 0.5%).
Each month, you and your neighbor continue to make the original mortgage payments on your houses, but you meet separately and exchange the difference between the two rates in cash. Since the cash received offsets any increase or decrease in your original rate, the agreement effectively swaps interest rates between you and your neighbor. These types of agreements are known as "interest rate swaps" in the financial industry and they are very common.
Why Interest Rate Swaps Exist
On the surface, it may seem strange for you to swap mortgages rates with your neighbor, but these types of transactions are very common in the financial markets. For example, fixed income investors who expect interest rates to fall could purchase floating-for-fixed interest rate swaps in order to pay a lower floating rate in exchange for the same fixed rate. Or, a hedge fund may use interest rate swaps to capitalize on arbitrage opportunities in the corporate credit markets.
Some estimates suggest that there are at least $200 trillion in notional value interest rate swaps in existence, with the top five banks, JPMorgan Chase, Citibank, Bank of America, Goldman Sachs and HSBC responsible for about 95% of the market. Many of these banks engage in interest rate swaps with municipal governments, who might prefer to swap floating rates for fixed rates on various bonds in order to make budgeting easier in future periods.
Risks of Interest Rate Swaps
Interest rate swaps may seem pretty straightforward, but they carry many risks that investors should carefully consider. Since swaps typically consist of one fixed rate and one floating rate component, there is a risk that interest rates could rise and cause floating rate losses or that interest rates could fall and cause fixed rate losses, which could also potentially increase the credit risk associated with the negatively affected counterparty.
In the past, some large banking institutions have amassed significant exposure to interest rate swaps, which can prove very dangerous given the occasional volatility of interest rates. The 2007-2012 global financial crisis led to a reevaluation of how interest rate swaps were priced to account for these risks. Traders are also required to mark to market interest rate swaps on a regular basis in order to visualize their inventory at any given time and understand the risk.
Considerations for Everyday Investors
Interest rate swaps may not be very common among everyday investors, but their impact on the financial system as a whole is enormous. Moreover, many exchange-traded funds (ETFs) and other commonly traded securities use interest rate swaps in their regular course of business, creating risks that investors should be cognizant of at all times. For instance, a currency ETF using interest rate swaps may be riskier than one trading just currencies.
The so-called swap curve may also be useful for investors trying to forecast interest rates in various countries. By plotting swap rates across all available maturities, the curve provides a snapshot of forward expectations for interest rates and reflects the market's perception of credit quality of banks participating in the market. For instance deviations between this curve and sovereign bond yield curves can impact interest rate expectations and currency values.