Interest Rate Swaps and Their Derivatives: A Practitioner's Guide

CHAPTER 3

Interest Rate Swaps in Practice

The previous chapter laid out the basic theory of pricing plain-vanilla interest rate swaps. As we saw, swap valuation boils down to extracting discount factors and using this discount factor curve to project and discount the cash flows. In this chapter, we consider the details of swap markets in practice using the USD market as our prime example.

In the United States, almost every major financial institution and corporation uses interest rate swaps. Like any other market instrument, swaps can be used for hedging or speculation. Commercial banks can use swaps to match the duration of their assets (long-term fixed rate loans) to their liabilities (short-rate deposits, CDs). Agencies use swaps and swap derivatives to fine-tune and hedge the duration of their mortgage portfolios in response to expected or realized prepayments, and for funding. Corporates typically follow a debt issuance (typically fixed-rate bonds) by swapping these to floating rates at opportune times (steep yield curves). Finally, speculators such as hedge funds and proprietary trading desks use swaps to express views or take advantage of level/slope/curvature of interest rate curves. Since swaps are over-the-counter (OTC) instruments, they are quite flexible and can be tailor-made to address one′s needs.

MARKET INSTRUMENTS

For the USD swap market, the benchmark floating index is the 3-month London Inter-Bank Offered Rate (LIBOR), which is the prevailing 3-month interest ...