This is part 10 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 9, we discussed regulation affecting swaps. In part 10, we’ll review the effectiveness of swaps and whether or not they should be used part of a hedging strategy.

Over the course of the series on interest rate swaps, we’ve reviewed the beginning s of swaps, different types of swaps, some examples of how swaps are used, special types of swaps used by central banks, and how swaps have impacted trends in regulation. In sum, it is an obvious conclusion that swaps are an integral part of financial markets, with estimates suggesting the depth of the market could be as little as $300 trillion to as great as $700 trillion  (the Bank of International Settlements pegs the dept at $415.2 trillion, as of 2006).

Although recent regulation (as discussed in part 9) could hurt the swaps market by removing some of the anonymous pricing mechanisms the OTC market provides, as well as thin out already thin exotic markets, it is unlikely that regulation clamps down on derivatives further unless there is a major financial crash involving swaps again, much like the U.S. housing crash in 2007/2008. Considering the vast amount of liquidity added to financial markets since the 2007/2008 crash (totaling several trillions of dollars), it is unlikely that such an event happens over the coming years.

We’ve also discussed the comparative advantage that comes with hedging via swaps: risks to profits can be reduced through the two main types of swaps, currency swaps and interest rate swaps. In part 6, we showed how Coca-Cola could access cheaper borrowing costs when looking abroad, and how through currency swaps, it was able to hedge away its foreign exchange rate volatility risk. Similarly, through interest rate swaps and forwards, JPMorgan was able to reduce risk transferred to it from Coca-Cola. Just like these theoretical companies, any company can use swaps to limit risk taking.

So where do swaps fit?

It should be noted that there are potential caveats to swaps. If a fixed rate is swapped for a floating rate, a rise in interest rates over the contract life could result in higher debt servicing costs. If interest rates are volatile from year to year (they tend not to be anymore among developed economies like Germany, Japan, the United Kingdom, and the United States), this could result in high profits one year or low profits in another.

If a floating rate is swapped for a fixed rate, the reverse can be said: while the party with the fixed rate is protected from interest rate volatility, it misses out on the opportunity to profit from the shifting rate environment. Through proper risk management using a tool like Hedgebook these problems can easily be avoided:

  • Instant fair value (mark-to-market) calculations for your transactions and sensitivity reporting remove the manual elements of complying with accounting standards such as IFRS7 and IAS39, and remove the reliance on your bank for fair values.
  • Sensitivity reporting also plays a valuable role in management of a portfolio by clearly demonstrating the effect that shifts in interest rates would have on the P&L.
  • Capturing a swap in Hedgebook is a simple process, with the entry of all of the key parameters of in a single deal input screen. Here the face value, maturity date, reset frequency accrual basis and coupon rate and coupon margins are entered and the swap is saved.

Hedgebook supports multiple variations of accrual basis, reference rate, business day conventions and swap curves to match the exact parameters of your particular swap. Once saved, the interest rate swap can be valued at any time based on Hedgbook’s daily rate feeds.

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