By: Emily Hollis, CFA
To function effectively, CFOs must be acquainted with a variety of interest rates—long rates, short rates, rates on government bonds, deposit rates, and mortgage rates. More and more, we are hearing CFOs tell us they are noticing a new rate getting attention in the financial pages: swap rates.
Swap rates are the fixed interest rate paid on an increasingly common financial derivative—the interest rate swap. These rates deserve attention in their own right.
Interest rate swaps are not like bonds or mortgages, so their interest rate measures something a bit different from the rates on those instruments. Interest rate swaps are an integral part of the fixed-income market. The total swap market is huge—measuring $710 trillion in notional size and dwarfing the $10 trillion U.S. Treasury market.
In the swap market, investors “swap” their interest rate risk exposure by converting a fixed-rate asset or liability into a variable-rate product. It’s a straightforward trade: The first counterparty agrees to make fixed-rate interest payments to the second counterparty and, in exchange, receives floating payments from the second counterparty.
The fixed rate of interest is called the “swap coupon.” The interest payments are calculated on the basis of a hypothetical amount of principal called “notional principal.” The notional principal is not exchanged; only the interest payments are exchanged.
If the counterparties’ payments to each other coincide, then only the interest differential between the two counterparties’ respective commitments needs to be exchanged. These swap counterparties can agree to pay a fixed rate for any term (e.g., two, three, five, 10, 15 years). The fixed rates on these terms are driven by the markets as they negotiate. The second counterparty will pay a variable rate, usually 3-month LIBOR for the determined period of time.