Interest Rate Swaps and Associated Risks

An interest rate swap when defined refers to a popular interest rate risk mitigation product used to manage likely exposure to the unprotected threats that are brought about by interest rate fluctuations. Conferring to this, Interest rate swaps are some of the most common trade derivatives and they are highly useful as an instrument for hedging by financial as well as non-financial corporations. In the most basic sense, a swap is a contractual agreement between two firms to exchange interest payments for a defined period, without necessarily swapping the underlying debt (Kuprianov, 1994). According to Simons (1993), the most common use of interest swaps is to change fixed-rate debt essentially into floating-rate debt and to transform a floating-rate debt into a fixed-rate debt. While it is possible to achieve this through other instruments, like futures, financial options as well as forward contracts, interest rate swaps offer benefits such as longer maturity and more flexibility. It is worth noting that the fast growth of the interest rate swaps market since its introduction has fuelled considerable debate concerning the economic rationale for such derivatives. Several observers have voiced concern regarding the growth and the size of the market, contending that swaps are a threat to the stability of financial markets. Others have argued that swaps expose banks to credit risks, especially the risk of non-performance by the counterparty.

Interest rate swaps are associated with several kinds of risk. Yang & Onur (2018) noted that some of the most notable types of risks are position, or interest rate risk and credit risk. According to Wall & Pringle (1988), interest rate risk or position risk occurs as a result of fluctuations in market interest rates that cause an adjustment in the worth of the swap. As market interest rates fluctuate, swaps generate either losses or gains that are equivalent to the variation in the swap’s replacement cost. These losses or gains allow swaps to act as a hedge which a firm can use to minimize its risk or act as a speculative instrument that increases the overall risk of the company. The problem facing a company that enters into a swap to gain fee income becomes more complex. A dealer firm may enter into a swap agreement to hedge changes in market interest rates or to speculate in the same way as a user firm. However, the dealer firm may also enter a swap agreement to meet a client’s request even when the dealer firm doesn’t want a change in its exposure to market interest rate. In such a case, the dealer firm must find a means of hedging the interest swap transaction.

Credit risk arises due to a default by either party in the swap agreement (Wall & Pringle, 1988). Yang & Onur (2018) also noted that besides the interest rate risk and the basis risk, both parties in the interest rate swap agreement tend to be vulnerable to the possibility of the other party defaulting and causing credit losses. Wall & Pringle (1988) further contend that the total value of the loss linked to this credit risk is evaluated by the substitution price of the swap, which is basically the cost of getting into a new swap given the prevailing market conditions with rates equivalent to those applied on the swap that is being replaced. Both participants in the interest rate swap are vulnerable credit risk at a certain point in the course of the swap contract. Nonetheless, only one participant at a time may be subject to this risk. It is also worth noting that both parties in the swap contract are vulnerable to each form of risk. One method of minimizing the credit risk linked to swaps is for the participant to whom the contract has a negative value to place collateral equivalent to the replacement cost of the swap agreement. However, most swap agreements do not have a provision for placing collateral.