Interest Rate Swaps the Assertion That Interest

Interest Rate Swaps The assertion that interest rate swaps require markets to be inefficient is inaccurate. While swap markets benefit from some inefficiency, firms may have compelling non-financial reasons for wanting to make changes to the timing of their cash flows, which is the basis for firms undertaking swaps. For these end users of swaps, the swap is most beneficial at fair value, and that is the price at which the swap will typically be set.

The counterparties are expected to agree on the expected future direction of the floating component of the swap, meaning that swaps depend more on efficient markets than inefficient markets -- the latter makes it more difficult for the counterparties to agree on fair value. Interest rate swaps are contractual arrangements between two parties, where they agree to exchange payments based on a principal amount, for a fixed period of time (CDIAC, 2007).

The most common type of swap is the plain vanilla swap, where one counterparty swaps the payments from a floating rate and the other counterparty swaps the payments from a fixed rate. The floating rate is often LIBOR and the fixed rates are often based on U.S. Treasuries (Ibid). The pricing of swaps is critical to understanding why the markets do not need to be inefficient. When the swap is made, the present value of the different cash flows involved is going to be equal.

If the present value of the two cash flows were not equal, then one of the counterparties would not want to make the agreement. However, a change in the prevailing interest rates would change the discount rate at which the future cash flows are discounted to present value. Thus, any change in the interest rate will benefit one of the counterparties to the detriment of the other.

At this point, however, anybody who enters into an interest rate swap to try to make money is engaging in an inefficient form of gambling. Most counterparties to an interest rate swap either have other motivations. Although interest rate bets are cited (Stern, 1999) as a motivator for entering into swaps, others are to adjust duration, overcome restrictions, manage basis risk and to derive comparative advantage such as through arbitrage (Ibid). For end users seeking an interest rate bet or arbitrage, interest rate swaps should function in an inefficient market.

For other uses, their benefits do not demand an inefficient market. Shifting the duration of the bond, for example, need not be a financially rational decision. The company may have strategic reasons for changing the duration of a bond. If there are cost advantages to doing so, it is still not necessary that these advantages are built into the market for the swap. Consider what it means for the swap market to be inefficient. An inefficient market is one that does not deliver accurate prices.

Counterparties to interest rate swaps rely on the market to be efficient, not inefficient, because they need to be able to price the two income streams equally at the time the deal is set. In an inefficient market, this might not be possible, although usually one counterparty has the flexibility to offer a fair value stream the other way (the bank, usually, can do this). Even interest rate swaps done for currency hedging do not demand inefficient markets.

The swap market, in order to exist, would need to be at least as efficient as the forward currency market, in order to attract any business. It should be noted that interest rate swap markets are subject to some inefficiency. The banks that act as counterparties do not do so out of the goodness of their hearts -- they do take spreads. While these spreads are typically low, this is only to attract business that might otherwise go to forward currency markets.

It is in the best interests of the banks to compete, which would make the swap markets more efficient. Inefficiency implies some form of knowledge that one counterparty has that the other does not. This is not usually the basis for a swap. The financial institution counterparty usually works on commission, taking a spread as payment for doing the swap. This commission is a form of inefficiency, but theoretically the swap market could exist without the banks as intermediaries.

It would be very difficult to find swap counterparties without the use of the banks, but technically it would be possible. The banks act as intermediaries because it is profitable to do so. Their fee is the price the counterparty is willing to pay to gain whatever benefit the counterparty is seeking (changes in duration, etc.). Thus, the.