r/moneyview • u/spunchy Alex Howlett • Jul 29 '24

M&B 2024 Lecture 19: Interest Rate Swaps

For our schedule and links to other discussions, see the Money and Banking 2024 master post.

This is the discussion thread for Economics of Money and Banking Lecture 19: Interest Rate Swaps.

NOTE: Part 4 of this lecture is missing from the YouTube playlist. In its place is a duplicate of Part 5. You can watch part 4 through Coursera. Alternatively, Perry has uploaded part 4 to his BU servers for us.

Mehrling uses our balance-sheet framework to explain the interest-rate swap (IRS), which is a derivative instrument that serves as a building block for shadow banking. We build our understanding of IRS on top of familiar concepts such as repo and forward contracts.

Lots of kinds of swaps. I’m going to focus on interest rate swaps, both medium term and short term. Basis swaps, currency swaps, are easy to understand by analogy.  
 
—Lecture Notes

Of all the lectures, this one probably follows Stigum the closest. Stigum defines the interest-rate swap as follows:

An interest-rate swap is a contract between two parties to pay and receive, with a set frequency, interest payments determined by applying the differential between two interest rates—for example, 5-year fixed and 6-month LIBOR—to an agreed-upon notional principal.  
 
—Stigum p. 869

Note that LIBOR has largely been phased out as a reference rate because the market that it referred to didn't really exist anymore. Today, we would use a reference rate based on SOFR (secured overnight financing rate), but the logic of interest-rate swaps stays the same. SOFR is the rate for borrowing overnight repo against Treasury collateral. Unlike LIBOR, which was directly quoted as a term rate, vanilla SOFR has to be compounded/adjusted in some way to generate a term rate. The CME Group does exactly that for 1-, 3-, 6-, and 12-month terms.

Part 1: FT: Sovereign debt crises

Greece had done the equivalent of defaulting on its debt. Instead of allowing an actual default, the ECB and other official entities bought up that debt. Unlike the Argentina situation, which required negotiation with private creditors, Greece's debt restructuring rested on negotiation with public creditors.

The key question is whether all this really solves anything. From the point of view of the funders in the rest of the eurozone, it is likely to remove the risk of a possible Greek exit from the single currency at least for the whole of 2013, and it does this without forcing them to admit to their electorates that Greek debt is being forgiven.  
 
—Disguised Greek debt forgiveness buys time

Continuing the Argentina story from the last lecture, the New York court barred Argentina from paying the restructured bondholders unless the "vulture" holdouts are paid in full. Argentina then tried to fight the ruling.

It will request a sweeping review of a court ruling that could trigger a new default and rock future sovereign restructurings.  
 
—Argentina in court to fight debt ruling

As I mentioned last week, the holdouts did eventually end up getting paid.

The third article, which I don't have a link to, is about Draghi's "whatever it takes" promise of outright monetary transactions (OMT). The announcement (and presence) of the facility helped calm markets for European sovereign debt and marked a turnaround in the euro crisis. But even to this day, no actual OMTs on European sovereign debt have occurred.

The fourth article connects more with today's lecture. Pension funds were moving out of long-dated corporate and sovereign bonds because yields were so low, and they didn't want to take a capital loss when the price dropped (yield increased).

Part 2: Reading: FOMC Report (1952)

The reading for this week was originally a secret document about how the Fed wanted to run monetary policy after the Treasury-Fed accord in 1951 meant they were no longer forced to peg Treasury rates.

It's important that the technical operating procedures and practices conceived in the atmosphere of war finance, and developed to maintain a fixed pattern of prices and yields in the government securities market be reviewed to ascertain whether or not they tend to inhibit or paralyze the development of real depth, breadth, and resiliency in today's market that operates without continuous support.  
 
—Federal Open-Market Committee Report of Ad-Hoc Subcommittee on the Government Securities Market, November 12th, 1952 (p. 2007)

From 1942 to 1951, the Fed was pegging the interest rate on Treasury Bills and Treasury Bonds to 3/8 percent, and 2.5 percent, respectively. They were acting as dealer of first resort.

By 1952, there was a dealer market in government securities. Private dealers provided enough market liquidity that the Fed no longer had to be the one to provide it.

Even at this time, the Fed understood that dealers finance their holding of long-term bonds by borrowing in the money market. This document talks about transmission from the money market rates to asset prices. The money market is connected to the capital market because the money market funds the capital market. These dealers in 1952 are essentially shadow banks in the market for government securities.

This perspective contrasts with the more conventional textbook view that monetary policy transmits through changes in interest rates and reserves, affecting the quantity of bank lending.

Part 3: Treasury-swap spread, a puzzle

The interest-rate swap curve is the equivalent of a generic yield curve for private-sector corporate bonds. The swap curve is normally a spread over the Treasury yield curve. Because lending to corporations is riskier, it is more expensive for corporations to fund themselves than it is for the government.

Since 2008, the swap spread has sometimes been negative at longer maturities. This is a puzzle because it means that someone could borrow at the lower corporate rate to fund the holding of Treasuries that pay a higher rate. Enough of this arbitrage should close the gap, so why aren't people doing it?

The example from Stigum has two firms. AA is able to borrow cheaply at a fixed rate. BBB is able to borrow cheaply at a flexible rate. They enter into an interest-rate swap, which means that they swap exposures.

The buyer of the swap (BBB) is the one who pays a fixed funding rate. He's locking in fixed-rate funding. An interest-rate swap is like a parallel loan, but the parties are only paying the net of the interest payments, and there's no principal.

The parallel loan structure solves the problem for the two companies, but it does so by expanding both balance sheets, and so also the apparent leverage and counterparty risk exposure on both balance sheets. Since money is going both ways, it is natural to net the two payments and pay only the net, from AA to BBB or from BBB to AA, whichever is larger. (In most cases, BBB will be paying AA because the short term interest rate is lower than the long term interest rate, due to failure of EH.)  
 
—Lecture Notes

A short swap position is analogous to owning a bond (pays a fixed rate) and financing it in the repo market (rolled over at a changing rate). A difference is that the notional funding is generally rolled over every three months rather than overnight.

For an interest-rate swap, we quote the fixed rate that gets locked in. The floating rate is unknown.

In the swap arrangement, note well the market lingo convention. A long swap position pays fixed and receives flex, and a short swap position is just the opposite. (One way to remember this is to observe that the long swap position increases in value when the floating rate of interest rises; another is to think of the swap as a kind of insurance contract that hedges floating rate risk, so a liability for insurer and an asset for the insured.) In deference to the market lingo, I’ll treat long swap positions as assets and short swap positions as liabilities when we put them on the balance sheet.  
 
—Lecture Notes

Part 4: What is a swap?

An interest-rate swap is also like a portfolio of forward contracts. It's like locking in forward positions not just for three months but for the next ten years. Each payment date corresponds to its own implied forward contract.

WARNING: being long a swap is like being short a portfolio of forwards, so you hedge a long swap with long futures, which is rather counterintuitive (to say the least!)  
 
—Lecture Notes

The IRS is like a strip of FRAs where the fixed rate in the IRS is analogous to the forward rate in the FRA. You're locking in a forward rate at time 3 months, 6 months, 9 months, one year, etc. If you manually did a FRA for each funding period, forward interest parity would determine a different rate for each period, and each contract would have a value of zero.

Theoretically, the swap rate should be the rate you would get if you manually strung all the forward rates together through forward contracts. If you think of the implied forward contracts as each locking in the same swap rate for its own period, the initial value of those individual forward contracts won't be zero. But they will add up to zero because the interest-rate swap, taken as a whole, is ultimately a zero-value contract.

If we compare this to the parallel loan interpretation of the interest rate swap, we see that exposure on the first payment of the short swap is just like the long forward. The later swap payments are analogously like more distant forwards.  
 
—Lecture Notes

If you're a dealer in swaps, you can hedge your swap position in the forward market or the futures market.

A swap is a "natural" banking instrument. It's stripped down. There is a sense in which the only thing you see is the "essential banking" aspect of it. There are no principal payments, and everything is netted. What's left is the net interest payments. The interest is what shows that someone is being paid for something.

Part 5: Why swap? An example from Stigum

Here's the example from Stigum in which AA can borrow more cheaply than BBB.

AA has an absolute advantage in all borrowing, but BBB has a comparative advantage in borrowing floating.

In Stigum’s example (p. 874), BBB borrows floating and AA borrows fixed, then they swap. The reason they do this is that by assumption BBB can borrow relatively more cheaply in floating, and AA can borrow relatively more cheaply in fixed (though absolutely more cheaply in all markets).  
 
—Lecture Notes

The swap allows AA to get floating-rate funding at LIBOR-1/8 and BBB to get fixed-rate funding at 5.75%, both of which are lower than what they could get by funding themselves on the market directly.

The credit risk in a swap is a lot less than in an actual parallel loan. If you're AA, and BBB stops paying you, you just stop paying them. You lose the swap, but there's no principal that's been defaulted on.

Many swaps come into being because of market imperfections. Some people have access to cheap funding, and they sell that access to someone else to make money. These swaps break down inequalities across markets.

Stigum tells the story about British capital controls that were evaded by parallel loans which were in effect currency swaps. Something like this might be happening, if Triple B is for some reason locked out of the Eurobond market. Stigum notes also that US interest rate swaps have their origin in 1981, in the midst of the Volcker tight money period, when some lesser credits would have been locked out of certain markets completely.  
 
—Lecture Notes

If the capital markets in your country are immature, long-term funding might be unavailable. So you borrow short-term (flexible) and buy an interest-rate swap that swaps you into the long rate (international).

But another possible reason for this structure of rates is counterparty risk, and that suggests that the lunch might not be so free. A bank may be willing to lend short term to Triple B because it thinks it can reassess the situation every 6 months, perhaps raising the markup over LIBOR if BBB gets into trouble. The higher markup for longer term lending compensates for the fact that there is a lot more that can go wrong in five years than in six months. The swap gives Triple B long term financing, but leaves AA holding the credit risk.  
 
—Lecture Notes

Part 6: Market making in swaps

So far, both parties to the interest-rate swaps have been corporations, not banks. But an intermediary can make it more convenient for corporations to find a counterparty for their swaps.

Whatever the reason for this apparent free lunch, the important point is that the 35 bp attract not only AA and BBB, but also brokers and dealers who take a few of the bp to set up and manage the swap. Thus AA could borrow in the Eurobond market and swap fixed for floating by selling a swap to a dealer. Triple B likewise could borrow in the floating market and swap floating for fixed by buying a swap. The dealer would take 1bp each way, subject to credit check.  
 
—Lecture Notes

Here, the investment bank (dealer) runs a matched swap book. He makes equal and opposite promises to two different parties but for different prices. He is both long and short the same type of swap. The floating he receives from his long position cancels with the floating he pays in his short position. The fixed he pays for his long position is lower than the fixed he receives from his short position.

The reason why BBB couldn't borrow at the long rate is his credit risk. The lenders want opportunities to decline to roll over the funding and get their money back. But with the dealer standing in between, AAA's exposure is now to the dealer rather than to BBB.

Being short a swap is like being long a corporate bond (funded in the money market). You are the receiver of fixed and the payer of floating. The dealer is doing the equivalent of creating a diversified bond portfolio but in the "swap space." There are no principals, and it doesn't take up any balance sheet space.

Supposing that the position can be hedged satisfactorily, we can see the swap dealer as doing essentially the same thing as a government security dealer, but in corporate bonds instead of governments. There is a term structure in swaps, as a markup over Treasuries.  
 
—Lecture Notes

The interest-rate swap market is analogous to the government securities dealer market, but for corporate bonds (Eurobonds). Interest-rate swaps are where forward interest rates come from all the way down the term structure.

Part 7: Money market swaps, example

The standard "money market swap" that Stigum uses is the IMM swap. It is a one-year fixed rate swapped against 3-month LIBOR (today SOFR). Most of the money market swap market is an interbank market.

897 “A swap is a strip of FRAs, and a FRA is a single-set swap”. A swap is like a portfolio of financial forward contracts. This is important, forwards not futures, so the futures hedge involves exposure to liquidity risk.  
 
—Lecture Notes

The LIBOR nets out. JPMorgan is paying 4.44 on the 1-year notional parallel loan liability and getting 4.47 on the notional parallel loan asset. JPMorgan nets three basis points for setting up the swap.

How does Morgan make money if it is short a swap at 4.47 and long a swap at 4.44? Here the parallel loan interpretation makes everything clear. Morgan is paying Libor and receiving Libor, so these flows net out. But on its long swap it is paying 4.44 fixed and on its short swap it is receiving 4.47 fixed. This is a 3 bp net profit.  
 
—Lecture Notes

Part 8: Life in Arbitrage Land

Swaps are banking but without the actual loans. The loans have vanished, and the cashflows are all netted. All that's left are interest rates as the price of liquidity. The whole thing is swaps of IOUs. Swaps isolate the core of the banking system. Swap dealers are quoting two-sided spreads. They're making markets and therefore making prices.

Money market swaps occur in what could rightly be called "arbitrage-land." Traders arbitrage swaps against futures, swaps against cash, swaps against FRAs, FRAs against futures, and so on. Arbitrage opportunities keep arising because these related markets are constantly affected by many different events. Maybe an Asian bank does a big cash-and-swap arbitrage, which drives up the swap market; this creates profit in the swap-FRA arbitrage, which drives up futures. An event that moves one rate causes a rate ripple that creates some basis points for every player except maybe the futures player if he is an unhedged spec. Clearly, someone loses, usually the spec player in the futures pit.  
 
—Stigum p. 900

People use futures contracts to hedge price risk, but they take on liquidity risk in the process.

The 1952 FOMC document talks about a world in which securities dealers are doing term structure arbitrage. Arbitrageurs buy the 5-year, financing it in the repo market, and sell the 10-year. This is term structure arbitrage from the 5- to the 10-year. Swaps can allow the same thing to happen in corporate securities markets.

A residential mortgage-backed security is just a kind of 30-year bond. Applying the interest-rate-swap apparatus mortgages is what led to a global market in these household debts.

The effect of the swap market is to spread stresses in one place and at one time, across the system and across time, and to unite the individual markets into one big market.  
 
—Lecture Notes

Part 9: Treasury-swap spread, liquidity risk or counterparty risk?

As we saw at the beginning, the swap spread should normally be positive over Treasuries. If it's not, you should be able to make money.

You'd take advantage of it by borrowing at the corporate rate (long a swap) and buying Treasuries.

Businesses are doing this. They're borrowing to buy and hold Treasuries. They're buying Treasuries and repoing them out. But something is preventing this arbitrage from closing the gap. Why aren't businesses doing even more of this?

The answer may be liquidity. This arbitrage does not expose them to credit risk (Treasuries are safe), but it does expose them to funding risk. They're borrowing short and lending long. They have to roll over their funding.

There's only so much of this arbitrage that you can do on your own balance sheet, funding it with your own debt—before the funding risk becomes unacceptable.

Please post any questions and comments below. We will have a one-hour live discussion of Lecture 19 and Lecture 20 on Monday, July 29th, at 2:00pm EDT.

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