Interest Rate Swap - OTC Product

The most highly traded product in OTC market which constitutes around more than 80% of the volumes. It helps the trader to manage interest rate risk for the portfolio. I will help you to understand its features, how they are traded and the motivation behind it in a real world.

As specified its an OTC trade. It helps to mitigate Interest rate risk for borrowing and lending within and across country border& also help to hedge your Bond portfolio exposure due to change in interest rate in the market.

Since its a derivative, the motivation of the trade, that is, be it hedging, arbitrage or speculation is very imp to know to understand the trade from an analyst or investor point of view

For example : Current date is 1st Jan-21. The interest rate in the market is 5%. I am speculating the interest rate will rise in next 2 years to 9% gradually, my friend has an opposite view of it, he thinks it will fall to 1% gradually. Based on our opposite analysis, we enter into a Plain vanilla IRS contract where I will be Fixed rate payer and my friend will pay me floating rate based on LIBOR Index for 2 year period settling the amounts of Profit and Loss every quarter on a notional amount of $1 million dollars.

The Int rate are always annualized and LIBOR is nothing but the average rate published which banks used to lend money for various maturities.

In March, if the interest did rise to 6 %, we will net the payments to each other, where I will receive net 1% * $1 million *3/12). Settlement will happen every quarter as agreed until maturity or we both close the trade before maturity, which happens in majority of the cases.

The trades can be Floating vs Floating ( Basis Swap ), Fixed vs Floating(Plain vanilla IRS), reset can be monthly, 3 months, 6 months. Other product type are Cross Currency Swap, OIS swaps, etc. Notional are not exchanged except in a Currency Swap it can be exchanged, not necessary though in reality.

In the above trade I was speculating, but if I also had a loan of Floating rate, then this trade will help me to hedge my risk.

If I am arbitraging, I may simultaneously enter an offset contract with diff cpty with Fixed rate as 5.1% if I find one.

Due to regulations post 2008 financial crises, various IRS products Cleared through Clearing house, that mitigates the credit risk by posting the margin with Clearing House (You can check my article on it)

If I have a Bond portfolio, my risk is Interest rate going up as my Bond prices will fall due to inverse relations which will make me have unrealized loss until I don't sell. I can enter into a Fixed rate payer swap to profit on IRS to mitigate my loss on Bond price fall. Since the Clearing house mitigates the Credit risk, with this trade I also mitigated the Interest risk. Though it sounds simple, there are many factors considered on the economic of IRS trade used to hedge the risk.

Do like & show your support and follow?#mustufapetiwala?for more content so that you get regular updates