The Capital Markets

CHAPTER 29Interest Rate Swaps

Amir Sadr

The interest rate derivatives market (swaps, options) is the largest segment of the global over‐the‐counter (OTC) derivatives market consisting of contracts on foreign exchange, interest rates, equity, commodity, and credit default swaps. According to the Bank for International Settlements (BIS), as of June 2015, interest rate contracts comprised $434 trillion (78%) of the notional amounts outstanding, or $11 trillion (71%) of gross market value. Of these contracts 90% were swaps—almost all plain‐vanilla swaps—and FRAs, and 10% options. Comparing the gross market value of swaps to the $12.7 trillion of U.S. Treasury outstanding debt should drive home the significance and size of this market.

In the United States, almost every major financial institution and corporation uses interest rate swaps. 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 usually 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.

Traditionally, swaps ...