Stock Market Guide to Interest Rate Swaps
Interest rate swaps are a type of Derivative transaction in which two participating parties swap, or exchange, positions in interest-bearing financial instruments for mutual advantage. The reasons for doing so are typically that one trader is seeking to reduce their exposure to interest rate fluctuations on the equity they currently own, assuming that equity (a bond or other interest-bearing note) has a floating interest rate.
Conversely, a trader who assumes that interest rates will rise may want to exchange an equity position with a fixed interest rate to one with a floating rate. Thus, by conducting an interest rate swap, both parties to the trade exchange positions of current equal value with the hope of some reward, be it a higher rate of return or simply added security, down the road.
Although the majority of interest rate swaps are of the “fixed versus floating” variety, “floating versus floating” swaps also occur, with the variable being either the security of the equity (for example, the rating of a bond) or the possibility that a certain type of interest-bearing equity will yield a higher rate of return in the future.
Although trading in interest rate swaps is a common type of over-the-counter derivatives, and is actually the most widely used type of derivative based on the total outstanding notational amount, they are not openly traded on futures exchanges even though they bear some similarity to basic options and futures contracts.
The problem is that interest rate swaps do not follow a standardized format, making them less liquid and therefore more difficult to trade through a futures exchange. It is therefore the major institutional traders, arbitrageurs and financial institutions who are the most active interest rate swaps traders. A leading example would be “Fannie Mae”, or the Federal National Mortgage Association (“FNMA”), who uses interest rate swaps and other forms of interest rate derivatives in order to hedge its cash flow moving forward.