Demystifying Financial Derivatives: Interest Rate Swaps and Municipal Derivatives

Article by Dr. Massimiliano De Santis1

SUMMARY

This paper reviews the economics of interest rate swaps and other interest rate derivatives. We begin by illustrating how interest rate swaps work and how they can be used to expand the set of financing options available to a company, to manage exposure to interest rate risks, and to speculate on interest rate expectations. Using recent municipal swaps as an example, we then illustrate potential issues of contention between swap counterparties and review the economic principles behind them.

While interest rate swaps offer a borrower potential cost savings justifiable on economic grounds, they may also expose him to risks not present in other financing alternatives. For example, a borrower that issues revolving debt and enters into a swap to hedge against interest rate changes is not in the same position of a borrower that borrows long-term at the same rate. The former is subject to changes in his credit risk whereas the latter is not. The Jefferson County, Alabama case reviewed in this paper is an example of a realization of this risk.

When interest rate swaps are used to hedge a company's exposure to interest rate risk, their ex-post performance in terms of financing costs may be inferior to an alternative that leaves a borrower exposed to interest rate risk. We argue that the economic soundness of a swap should be evaluated on an ex-ante basis, taking into account its risk-return trade-off relative to alternative financing options.

We also review some common swap pricing practices important in determining the value of a swap and understanding swap-dealer fees. While a standard principle in swap pricing is the mid-market pricing, or zero net present value, in practice the net present value of a swap at inception is positive for a dealer. We review the main adjustments dealers make to arrive at a fair market value, including credit risk, profit margins, and liquidity adjustments. The adjustments should rely on sound economic models, and the models should make appropriate risk adjustments to expected losses and expected defaults.

1. INTRODUCTION

   While the role of financial markets in facilitating lending and providing investment capital to business often steals the limelight, the role of the financial system in facilitating the separation and trade of economic risks is no less essential to economic growth. The idea is that trading risks lowers the cost of financing risky projects by separating one risk from another and placing each with the party that is able to bear it at the lowest cost. Financial derivatives are contracts that facilitate the separation and trade of economic risks.2

   This paper reviews the economic benefits of one type of contract designed to trade in risk, interest rate swaps, and related interest rate derivatives. By allowing two parties to swap cash flows, interest rate derivatives expand the set of financing options available to borrowers. This allows them to lower financing costs, manage mismatches between assets and liabilities, and manage their exposure to interest rate risk. Some of the earliest interest rate swaps were done by Sallie Mae in the early 1980s with the goal of reducing the duration of its liabilities. Since then, the market for interest rate derivatives has increased exponentially. According to the Bank for International Settlements (BIS), the global notional amount of interest rate derivatives (including interest rate swaps and other derivatives described below) was about $347 trillion as of June 2010.3 The amount was $51 trillion as of June 2000 according to the same source, and only $182 billion in 1987, according to data from the International Swap and Derivatives Association (ISDA).4

   This paper is motivated in part by recent activity in the market for municipal interest-rate derivatives. Just like companies in the private sector, states and local governments have sought to benefit from interest rate swaps, and the market for municipal interest rate derivatives has experienced similar growth. For example, today, 70% of issuers of variable-rate demand obligations (VRDOs), a certain type of long-term floating rate bond, have entered into interest rate swaps.5 With the increased usage, the economic soundness of some municipal swap transactions has been questioned recently, and some local governments are bringing lawsuits against the financial institutions that wrote the swaps. A wave of allegedly suspect municipal swap transactions has surfaced both in the US and Europe, and Italy in particular. We review some of the economic aspects of current and potential litigation in Section III.

   Like most financial assets, interest rate swaps have inherent risks. Some of these risks can be off-set by other risks on the balance sheet of a business or a government entity, in which case the swap can be used as a hedging instrument. Other risks are swap-specific though, and may or may not be easily mitigated. All these risks need to be considered in deciding among alternative financing options. Further, when using swaps as hedging instruments, a user gives up potential gains in some states of the world in exchange for protection from potential losses in other states of the world. This implies that there may be a difference between ex-ante optimality and ex-post performance of a given swap. Questions related to risks, optimality, and performance of swaps are elements of contention in recent swap litigation.

   The next section describes the basic functioning of a (plain vanilla) interest rate swap. Section III describes the use of interest rate swaps by municipalities, and gives a high-level overview of recent litigation involving municipal interest rate swaps in the US. We also give an overview of similar litigation, some with potentially high stakes, brought by local governments in Italy. In Section IV we analyze the economic benefits of swaps and discuss economic aspects of interest rate swaps that are of relevance in current and potential swap litigation.

2. INTEREST RATE SWAPS

   An interest rate swap is a periodic exchange of fixed coupon payments by one counterparty (called the fixed-rate payer) in return for variable-rate payments by another counterparty (called the floating-rate payer), until a stated maturity.6

   By combining interest rate swaps with alternative financing options, interest rate swaps increase the number of ways in which a firm can borrow. This can lead to lower borrowing costs and better interest rate risk management. The following example explains how a swap between two counterparties works.

   A relatively risky borrower, BBB Corp., needs a fixed rate to finance new long-term investment. The company can finance the investment either by borrowing from a bank or in the direct market by issuing bonds. The company is able to borrow from the bank at a variable rate of LIBOR + 2%.7 Because it is a company with a relatively large default risk, it can only issue bonds at a rate of 10%. Next, consider a good credit risk, AAA Corp., which would like to borrow at a variable rate. Because it has high credit ratings and a low probability of default, the company pays LIBOR + 1% on its bank loans and can issue bonds at a rate of 7%.

   Assuming LIBOR is 5%, the following table shows the interest rates faced by the two companies in the two different markets:

   BBB Corp. pays more to borrow in both markets. However, the bond market requires a quality spread 3% larger than the bank loan market (4% - 1%). BBB Corp. is said to have a comparative advantage in the bank loans market, while AAA Corp. is said to have a comparative advantage in the bond market.

   Without swaps, BBB Corp. can meet its financing needs by borrowing long term at 11%, and AAA Corp. by taking a renewable bank loan at LIBOR + 1% (6%). Alternatively, they can each borrow from the market in which they have a comparative advantage, and then swap the payments.

   Assume both companies need $10 million in fresh capital. BBB Corp. takes a renewable loan at LIBOR + 2% (starting at 7%) from its bank; AAA Corp. issues a 10-year bond at a 7% rate. Under the terms of the 10-year swap for a $10 million notional principal, BBB Corp. pays a fixed rate of 9% to AAA Corp., and AAA Corp. pays 2% over LIBOR to BBB Corp.

   Notice the fixed rate paid by BBB Corp. is two percentage points below the rate it would pay if it issued 10-year bonds. AAA Corp. pays LIBOR + 2% in the swap, but receives a spread of 2% over its fixed interest payment in the bond market from BBB Corp., so it ends up paying LIBOR after the swap, a gain of one percentage point. The total potential gain from trade is three percentage points. We analyze this potential gain from swaps in more detail in Section IV.B.

   1. Pricing vs. Value of a Swap

      In the example above, we have taken the fixed rate on the swap as given. This rate depends on several factors, some of which are explained below. Determining the fixed rate at inception is referred to as pricing of the swap. The swap is priced so that there is no upfront cash exchange between the parties involved.

      In practice, the fixed and floating payments are offset (or netted) against each other as of each payment date, and the party paying the higher rate of interest remits a payment to the counterparty equal to the notional amount multiplied by the difference between the interest rates. So that if the swap rate (9% in our example) is greater than LIBOR, the fixed-rate payer pays

      (swap rate – LIBOR) × notional principal.

      If LIBOR is greater than the swap rate, the floating-rate payer pays

      (LIBOR – swap rate) × notional principal.8

      The swap rate determined at the inception of the swap reflects, among other things, market expectations about future LIBOR rates and about the future ability of both payers to make the payments. The rate at inception makes the swap a fair wager so that neither party is favored at the expense of the other. Supply and demand in the market for swaps...