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Interest Rate Swap

INTEREST RATE SWAPS AND FINANCIAL INSTITUTIONS

INTEREST RATE SWAPS AND FINANCIAL INSTITUTIONS
INTRODUCTION
Interest rate swap transactions began in 1981, with Eurobonds being the principal security employed in these transactions. In a span of only seven years, interest rate swaps have developed into a fully operative market with an annual volume estimated to be over $300 billion and outstanding swaps
with a value over $1 trillion. Although swaps were originally devised to deal with interest rate volatility, a wide variety of new uses has evolved for this unique instrument. This paper will explore many of these new and innovative uses of swaps. Any instrument undergoing the rapid growth that swaps have experienced will encounter critics. In particular, some financial commentators fear that the rapid and uncontrolled growth of this market will pose serious problems for the financial security of the credit markets. Swaps are criticized for masking an institution's true interest rate exposure and for increasing overall credit risk. A discussion of accounting issues and credit risk is covered later in this paper. However, it does seem rather ironic that an instrument which was born out of deregulation is now coming under considerable pressure for increased industry control. Swaps allow users to lock-in their cost of funds, rapidly alter their asset-liability structure, create synthetic 4 securities, access cheaper credit markets, and speculate on interest rate movements (even though existing regulations prohibit such speculation). The growth in swaps has resulted in a relatively broad secondary market and the standardization of the underlying contracts and conventions among instruments. In fact, many of the changes which have occurred in the swap market are identical to the ones experienced during in the development of futures markets.
OVERVIEW TO INTEREST RATE SWAPS
THE BASICS
The concept of an interest rate swap is relatively simple: two parties agree to...