Interest rate swaps are extremely popular in financial markets. Not only are they traded, but they are also used as tools that indicate future market expectations for interest rates. We analyze what an interest rate swap is and how to use the IRS market to derive information.
Content
- Introduction
- Benchmark Variable Interest Rate Index
- The Fixed Interest Rate
- How Interest Rate Swaps influence the Mortgage Market
- Why the Math is sometimes different for US Mortgages
Introduction
A swap is any type of financial derivative where two counterparts decide to exchange, or swap, a series for payments. In the case of interest rate swaps, interest payments are exchanged. Interest rate swaps are used to hedge interest risk and speculate on the future direction of interest rates.
Interest rate swaps are the most common swap traded by financial market participants. They are known by its acronym IRS. Not to be confused with the tax agency.
An interest rate swap is an agreement in which one entity agrees to pay a fixed interest rate, and the other agrees to pay a variable interest rate such as the Fed Funds rate. As you can see, it is a simple exchange of future interest rate payments.
The length of an interest rate swap is fixed in advance. They can be as short as just a few months or even 100 years in duration. Regardless of their length, they all work the same way.
An IRS allows to convert a future stream of fixed interest rate payments into variable interest rate payments, or vice versa.
The interest rate swap market is tremendously liquid. Many financial institutions and investors use it, including banks, insurance companies, investment funds, non-financial corporations, pension funds, etc.
Benchmark Variable Interest Rate Index
A very important characteristics for an interest rate swap is the interest rate index used as a benchmark to decide what the variable interest rate payments will be. There are plenty of interest rate indices that fluctuate constantly. Based on the value of those variable indices in the future, interest rate payments will be made.
For example, an interest rate swap denominated in US Dollar could use the Fed Funds rate or the 3-month US Libor index as its benchmark interest rate. In the case of interest rate swaps in Euros, they could be using indices such as ESTR or 6-month Euribor.
If an interest rate swap uses the 6-month Euribor rate to calculate the variable interest payments, we will observe the value of that index every 6 months and, based on its value, the interest rate for the following 6 months will be set. This process will be repeated all over again every 6 months until the swap matures at a predetermined date.
The Fixed Interest Rate
The fixed interest rate will be paid by the other part in the interest rate swap. As its name indicates, these payments will be fixed throughout the duration of the swap. Therefore, if the fixed rate payer agrees to pay an interest rate of 3% for the next 5 years, a payment of 3% of the notional of the swap will be made every year for 5 years. In exchange, a variable interest rate payments will be received.
The fixed rate of an IRS is mostly determined by the market and depends on the duration of the swap. A swap maturing in 5 years will have a different fixed interest rate than a swap maturing in 30 years. Fixed rates are determined by supply and demand in the market.
When the market expects interest rates to rise in the future, fixed interest rates for an interest rate swap will increase, reflecting those expectations. If the market believes that interest rates are going to drop, fixed rates will go down in anticipation of that.
The interesting thing is that, at any given time, a fixed swap rate indicates the average interest rate expected over that period. If the fixed rate for a 10-year interest rate swap is 4%, in exchange for variable payments determined by the floating Fed Funds rate, that indicates that the market expects the Fed Funds rate to average about 4% over the next 10 years.
As you can see, the fixed interest rate of a swap is the price at which we can exchange fixed interest payments in exchange for variable interest payments. The swaps market is very large and liquid. Although it receives very little coverage from the financial press, it is tremendously important. At the end of the day, it can be used to see the market expectations for future interest rates and, therefore, monetary policy and the state of the economy.
If you want to know what the fixed interest rate for a swap of a given maturity is (say 5 years), you just have to Google it. This information is easily available. Another option is to use ICE’s website.
How Interest Rate Swaps influence the Mortgage Market
In many countries, mortgages can have both fixed and variable interest rates. If we choose a fixed rate mortgage, we know in advance exactly how much our payments will be. If we take a 30-year mortgage with fixed interest rate of 5%, we know how much we will pay every month for the next 30 years.
On the other hand, if we take a variable interest rate mortgage, which are common in some European countries, our interest rate will be reset on a regular basis. For example, if our mortgage tracks the 6-month Euribor rate, our interest rate will change every 6 months. Whether this is good or bad will depend on whether interest rates go up or down.
Putting our preferences aside, the interest rate market can tell us roughly how high the fixed interest rate of a mortgage should be relative to a variable interest rate mortgage.
If the fixed interest rate for a 20-year swap in Euros is 3%, that means the market expects the 6-month Euribor rate to average 3% over the next 20 years.
Assuming that the lender offers us the option to take a 20-year variable mortgage where our interest rate will be Euribor plus 1%, we can easily find out how much a fair fixed interest rate for a 20-year mortgage will be. We simply need to replace the index with the 20-year swap rate. Therefore, a 20-year mortgage should be available with a fixed interest rate of roughly 4%.
Why the Math is sometimes different for US Mortgages
In some countries, the borrower has the option to refinance their fixed rate mortgage at any time without paying any penalties. This is especially true in the United States.
This means that the borrower effectively owns an interest rate option. If interest rates go up, they will continue to pay the fixed interest rate. If interest rates go down, they can refinance and start paying a lower interest rate.
This interest rate option has a value and is the reason why the fixed interest rate for a mortgage will be higher than what we can expect by simply looking at the fixed interest rate for an interest rate swap.
For example, if we continue with our example above, if the bank offers us a fixed interest rate of 5% for a 20-year mortgage, but we have the option to refinance at any time without paying any penalty, this means that the bank is pricing that option at 1%.
In other words, we can either choose to pay 4% interest for 20 years, or 5% with the option to take on a cheaper mortgage at any time.
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