Wednesday, June 03, 2009

Interest rate swaps

Felix Salmon with a practical application of the interest rate swap.

With interest rates low, GM was actually making money on these swaps: the banks would pay it the difference, every six months or so, between the higher fixed rate and the lower floating rate. But now that GM is bankrupt, the swaps have been torn up, and all those future payments which the banks were expecting to make no longer have to be made.

Of course, banks always hedge their positions — which means that some other counterparty will continue to pay them the money they were expecting to have to pay to GM. That's what Jansen means when he says that the bank “is long”. Now that money isn't going to GM, the bank will want to hedge its new long position, which essentially means selling that cashflow in the swap market.

A cashflow is like a bond, and when you sell bonds their yields rise. Similarly, here, when a bank hedges its new long position, yields — which in this case are swap spreads — go up. That's what Jansen means when he says they're “under pressure”. (A swap spread is the difference between the yield on the cashflow the bank is selling, and the yield on Treasury bonds of the same maturity.)

1 comment:

David Darten said...

Great point in Interest rate swaps. Because the return on investments with floating interest rates fluctuates with the market, they’re more difficult to manage than fixed-rate investments. Money managers frequently swap floating rates for fixed rates in a rate swap in order to lock in a rate and allow for planning.

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