Interest Rate Swaps and Fair Value
Interest rate swaps are over-the-counter derivative contracts between two parties that agree to exchange periodic interest payments on referenced notional amounts. The swapped interest payments may be based on fixed or floating rates in one or more currencies. Interest rate swaps allow firms to manage their exposures to fixed and floating rate assets and liabilities. Speculators can also use interest rate swaps to create positions designed to profit from changes in interest rates. This article presents a brief discussion of interest rate swaps and related fair value considerations.
Background
Interest rate derivatives, including swaps, are used by a large number of firms based in the U.S. and around the world. According to the Securities Industry and Financial Markets Association, all 30 companies that comprised the Dow Jones Industrial Average used interest rate derivatives in 2007 and 2008.' Non-financial companies (the retail counterparties) typically enter into interest rate swap agreements with securities dealers, who are also active in the inter-dealer market. The overall market for interest rate swaps has grown substantially in recent years and is generally considered highly liquid. A survey of the derivatives markets in 11 industrialized countries conducted by the Bank for International Settlements indicated that the notional amount outstanding on interest rate swaps totaled $328 trillion at the end of 2008, up from $36 trillion at the end of 1998.
The most common interest rate swap arrangement involves a party that agrees to pay interest based on a fixed rate, while the other agrees to pay interest based on a reference floating rate (typically three-month LIBOR) in the same currency. These contracts are commonly referred to as plain-vanilla interest rate swaps, which allow firms to hedge their exposures to fixed or floating interest rates according to their appetite for (interest rate) risk. For instance, a firm with a liability whose interest payments are based on a floating rate can enter into a fixed-for-floating plain-vanilla interest rate swap contract as a hedge against potential future increases in interest rates.