Interest Rate SWAPS - Literature review Example

Interest Rate SWAPS Literature Review Derivatives is considered to be a particular instrument or product worth of which is obtained as a result of more than one fundamental variables referred as an underlying asset, value associated with the reference rate and index by way of a contract. The specified underlying or rather the fundamental asset is probable to exist in the form of forex, equity, commodity or even other existing relevant asset. There have been stated to be numerous forms of derivatives contracts that are being used among which interest rate swaps is considered to be a common form (Hunt & Kennedy, 2004). According to Pelsser (2000) the market related to derivative securities has been stated to be perceived similar to an insurance market in relation to the considered financial risks. The rapid rate of globalisation in terms of the capital markets has resulted in a significant rise in the level of volatility related to interest rate across the globe. Numerous companies displayed a preference in favour of purchasing insurance in opposition to the rising improbability and instability with regard to the market linked to interest rate. Owing to this particular rationale, the market related to interest rate derivatives witnessed a sharp rise and development during the past two decades (Crotty & North Carolina State University, 2006). It was stated by Whaley (2006) that interest rate derivatives are referred to those kind of derivatives which are supposed to make available the pay-offs that are ascertained by the way of alterations that takes place in the interest rates. The similar derivative products that were made use of with the intention to handle and deal with the risks related to foreign exchange were found to posses the competence of managing the risks related to interest rates as well (Kohn, 1990). The popular form of derivative product that was found to be used in this context was the interest rate swaps. The recognition of the application and implementation of this particular form of derivative was believed to be triggered for numerous reasons. Majority of the businesses has been observed to witness certain specific kinds of risk related to interest rates. The usage of Over-The-Counter (OTC) related interest rate derivatives was regarded and identified to be the best possible way of dealing with the risks related to interest risk in the period of 1980. The advantage of tailoring or modifying the risks associated with interest rates in accordance with the requirements of a particular risk manager was attributed to be the major cause behind its popularity. Interest rate swaps have been recognised to be the most extensively applied form of interest rate derivative (Grant & Marshall, 1997; Bodnar & et. al., 1995; Moffet & Karlsen, 1994). Interest rate swap has been stated to be quite an effectual instrument. It is competent of being structured at quite a decreased degree of cost and is also supposed to be less pricey in comparison to a fresh loan with a fixed rate (Schaeffer & Ludwig, 1993). According to Coyle (2001), the concept of interest rate swap is referred to the swap over of payment of interests based on a theoretical amount with regard to the principal. In such instances, one particular party is believed to disburse a preset interest rate with regard to the principal amount for the duration in relation to the swap. Similarly, the other involved party continues disbursing a floating interest rate which is attuned or rather periodically altered. The notion of interest rate has been explained as the sum of money or funds that is assured to be paid by a particular borrower to the concerned lender. The usage or the execution of an interest rate is learnt to be dependent on the degree of relative credit risk as it is believed that the more the expected degree of credit risk, the rate of interest that is assured by the specific borrower also soars and gets increased in relation to it. The interest rate swap is considered to be quite popular and has been stated to be amongst the chief financial innovations (Buetow & Fabozzi, 2000). The market associated with interest rate swap is regarded as an imperative source of fixed-income market with regard to the dealings as well as hedging related to interest risk (Brown & et. al., 1994). The chief kind of an interest rate swap has been stated to be the plain vanilla swap where a particular set of disbursement is considered to be permanent or predetermined whereas, the other is supposed to remain in the floating form. This particular kind of swap was learnt to be the largest and imperative form of financial derivative across the globe comprising above US$25 trillion on the accessible and prevalent agreements during the period of 1998. There was found to be several kinds of motivations for two parties with the intention of entering into such an agreement related to interest rate swaps. A particular corporate borrower in command of a strong credit standing might perceive probabilities for an increased in the interest rates. The initiation of getting into a specific swap agreement for the reason of paying ascertained and unchanged interest rates along with being paid with floating form of interest rates would enable the borrower to safeguard the companies against mounting expenses related to debt-service. Majority of the companies as well as banks have been found to make use of these interest rate swaps for controlling the payment system related to their respective liabilities (Grant & Marshall, 1997; Bodnar & et. al., 1995; Moffet & Karlsen, 1994). The interest rate derivatives have been stated to be the most popular form of Over-The-Counter (OTC) instruments that are implemented or engaged by the banks along with different investors for the reason of hedging or dealing in such risks (Mahfoudhi, 2006). In the period of 1980s and even 1990s, the implementation of the interest-rate derivatives was believed to bestow the various banks with prospects of effectually dealing with their respective exposure related to the interest-rate along with facilitating them to reap revenue apart from the customary banking functions or operations. This increased implementation of interest-rate derivatives made the banks build up significantly huge positions with regard to this particular form of asset which is considered to be off-balance sheet (Brewer III & et. al., 2000). The increased indulgence of the banks in such assets made them to be considered as increasingly active members in the markets related to such derivative products. The active involvement of the banks reduced their respective function of providing credits (Gup, 2011). A significant growth and transformation of the securities related to financial derivatives as an imperative and contentious product was witnessed in the past few years. These derivative securities are considered to be influential instruments for the reason of moving or shifting as well as for hedging risk. However, it has also been found to be mentioned in this regard that these securities even facilitate agents to rapidly as well inexpensively indulge in speculative risk. The association that exists among derivatives and risks are considered to be specifically significant in the field of banking as they are believed to rule over and control majority of the markets related to derivatives. The derivative holdings within the industry of banking have been found to be concerted and intense with respect to few of the big and renowned banks. The net position associated with the banking system has been estimated to be fairly responsive to the interest rates. Comparatively, lesser degree of augmentation in the interest rates is predicted to act as a source of reasonably larger degree of turn down in the values associated with the swaps that are possessed by the respective banks. The interest rate swap is believed to be a particular contract according to which two specific parties agree to exchange their respective disbursements related to the net interest on the basis of a particular amount which is usually regarded as “notional principal” (Samuelson, 1945). It has been stated in this context that though an exchange gets initiated for the interest rates but the particular notional principal of the respective parties are by no means exchanged. By principle, the rate of interests with regard to an agreement of swap is ascertained with the intention that the market value associated with the contract at the time of initiation remains at zero. In case of any unexpected alterations made in the interest rates, the prevailing market value with regard to a swap also undergoes an alteration and turns out to be an asset in relation to a particular party as well as a responsibility for the other existing counterparty (Gorton & Rosen, 1995). Ascertainment of the value of a swap of interest-rate calls for the necessity of information regarding the time of initiation of that particular swap, the specified payment conditions along with the outstanding maturity related to the agreement of swap. The vital element while ascertaining the risk associated with a particular swap portfolio has been measured to be the degree of sensitivity in relation to the interest-rate associated with the particular portfolio. The value of a swap tends to get quite volatile at times. A slightest degree of alteration in the interest rates can result in a dramatic alteration in the value related to a swap. Therefore, keeping a check on the risks that are likely to arise from the entered swap agreements is considered to be quite complicated and tricky (Borokhovich & et. al., 2004). The banks are learnt to encounter increasingly grave issues in the course of making use of derivatives or rather interest rate swaps owing to mainly two significant causes. The initial cause accounts for the limitations posed on the external stakeholders who are considered to be more knowledgeable regarding the position of the derivatives by the banks for the reason of ascertaining the overall degree and intensity of risks that the banks are likely to encounter. Banks have been observed to put in their respective funds in numerous non-derivative instruments or products that are regarded as opaque as well as illiquid. Therefore, in spite of being aware of the value associated with the respective derivative position of the banks, it becomes complicated and tough to ascertain the degree and extent of interest rate as well as other form of risks that the banks are likely to witness. This particular aspect differentiates the banks from majority of the different companies who are believed to employ their respective funds in derivatives (Borokhovich & et. al., 2004). The other cause that holds immense probability of exposing the banks towards grave problems associated with the usage of interest rate swap has been stated to be the external consequences that are probable on the failure of a particular bank. The collapse of numerous large banks has been measured to trigger the failure of the overall payments method followed by the breakdown of the credit markets with regard to the various companies or organisations. These mentioned issues which are collectively referred to “systematic risk” remains to be a huge concern if all the existing large banks decide on taking analogous positions in relation to the derivatives market. It becomes quite lucid that the collapse of a particular bank might imply the collapse of the other in case the banks are observed to display alike positions (Gorton & Rosen, 1995). Banks have been referred as mediators among the borrowers as well as the lenders. Owing to numerous different competitive causes, the banks become compelled to receive funds from their respective clients with changeable period of maturities that possesses prospective to change the formation related to a particular bank’s balance sheet to a certain position that is measured to be increasingly responsive to the interest rate (Staikouras, 2006). The risk related to interest rates has been stated to be a major concern for the banks which is believed to be initiated and triggered from the existing difference in the maturity time periods of the assets as well as the liabilities (Song, 2004). Banks have been frequently referred to being responsive to the liability or the asset in relation to the system of maturity connected with their respective portfolio. A bank that is considered to be responsive to asset is stated to possess a book that is long funded implying that the assets of short-term nature are financed with the help of liabilities that are of long-term nature. The risk related to the interest rate in this context can be observed to be the requirement of the assets to be employed again till the time they are required to pay back the liabilities. Therefore, interest rate swaps have been observed to be the effectual application which prevents the banks from encountering a situation of declining interest rate. The interest rate swaps are applied and implemented in this respect to employ the assets at decreased rates in comparison to the prevailing rate payments associated with the liabilities (Gorton & Rosen, 1995). References Bodnar, G. M. & et. al., 1995. Wharton Survey of Derivatives Usage by US Non-Financial Firms. Financial Management, Vol. 24, pp. 104-33. Borokhovich, K. & et. al., 2004. Board Composition and Corporate Use of Interest Rate Derivatives. Journal of Financial Research, Vol. 27, Iss. 2, pp. 199-216. Brewer III, E. & et. al., 2000. Interest-Rate Derivatives and Bank Lending. Journal of Banking & Finance, Vol. 24, pp. 353-379. Brown, K. C. & et. al., 1994. An Empirical Analysis of Interest Rate Swap Spreads. Journal of Fixed Income, Vol. 3, pp. 61-78. Buetow, G. W. & Fabozzi, F. J., 2000. Valuation of Interest Rate Swaps and Swaptions. John Wiley and Sons. Coyle, B., 2001. Interest-Rate Swaps. Global Professional Publishi. Crotty, M. T. & North Carolina State University, 2006. Assessing the Effects Of Variability In Interest Rate Derivative Pricing. ProQuest. Gorton, G. & Rosen, R., 1995. Banks and Derivatives. The National Bureau of Economic Research, Vol.10, pp. 299-349. Grant, K. & Marshall, A. P., 1997. Large UK Companies and Derivatives. European Financial Management, Vol. 3, pp. 194-208. Gup, B. E., 2011. Banking and Financial Institutions: A Guide for Directors, Investors, and Counterparties. John Wiley & Sons. Hunt, P. J. & Kennedy. J. E., 2004. Financial Derivatives in Theory and Practice. John Wiley and Sons. Kohn, K., 1990. Managing Foreign Exchange Risk Profitability. Columbia Journal of World Business, pp.203-207. Mahfoudhi, R. M., 2006. Term Structure Models and Interest Rate Derivatives: Literature Review and Numerical Implementation. Laval University, pp. 1-59. Moffet, M. & Karlsen, J., 1994. Managing Foreign Exchange Rate Economic Exposure. Journal of International Financial Management and Accounting, Vol. 5, Iss. 2, pp. 157-175. Pelsser, A., 2000. Efficient Methods for Valuing Interest Rate Derivatives. Springer. Samuelson, P. A., 1945. The Effect of Interest Rate Increases on the Banking System. American Economic Review, Vol. 35, Iss. 1, pp. 16-27. Schaeffer, M. S. & Ludwig, M. S., 1993. Understanding Interest Rate Swaps. McGraw-Hill Professional. Song, C. J., 2004. Are Interest Rate Swaps Used to Manage Banks’ Earnings? Michigan State University, pp. 1-58. Staikouras, S. K., 2006. Financial Intermediaries and Interest Rate Risk: II. Financial Markets, Institutions and Instruments, Vol. 15, Iss. 5, pp. 225-272. Whaley, R. E., 2006. Derivatives: Markets, Valuation, and Risk Management. John Wiley and Sons. Read More