In any risk-management assessment, there is always the option to do nothing, and that is what many people do. However, in circumstances of unpredictability, sometimes not hedging is disastrous. Financial derivatives are the way-out.
Financial derivatives are useful for dealing with various types of risks, mainly market, credit and operational risks. The importance of derivatives has been increasing since the instrument has been used to hedge against price movements. The financial tool assists with transfer of risks associated with a specific portfolio without requiring selling of the portfolio itself. Essentially, derivatives allow investors to manage their risks and so reach the desired risk profile and allocation more efficiently. Interest rate swap, a widely used derivative or hedging tool for stronger risk management, helps to limit or manage exposure to fluctuations in interest rates or to acquire a lower interest rate than a company would otherwise be able to obtain.
Theoretically, interest rate swap is an exchange of cash flows, especially interest payments or receipts based on a specified notional principal amount between two parties at pre-determined rate, tenor and terms. Interest rate swaps are fast gaining popularity among investors, speculators and banks, as these transactions are mostly based on market expectations for interest rates. According to the Bank for International Settlement (BIS), the total outstanding of interest swaps in all currencies stood at US$ 13,946 billion in 2014 which was US$ 1,018 billion in 1998. Interest rate swaps are used by commercial banks, insurance companies, investment banks, lenders, mortgage companies and government agencies. An interest rate swap is based on a notional principal amount, which is used to calculate the amount payable by both the parties. However, this principal amount is never exchanged.
It is basically a contract between two parties (often between a large bank and a corporation) to exchange the interest payments if both expect a substantial fluctuations of interest rates for an identical period of time. Invariably, interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset's value resulting from variability of interest rates. Interest rate risk management has become very important and assorted instruments have been developed to deal with interest rate risk. Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead. This calls for a zero-sum game rather than a win-win situation for both parties.
There are several types of interest rate swaps:
n Fixed-for-floating rate swap in same currency: This type of swap allows one party to pay fixed interest payments, while receiving payments from the other party in floating interest rates and vice versa. This is the most popular form of rate swaps and is called a vanilla swap.
n Floating-for-floating rate swap in same currency: This type of interest rate swap is used when floating rates are based on different reference rates. For example, one interest rate could be pegged to the LIBOR (London Interbank Offered Rate), while another to the MIBOR (Mumbai Interbank Offered Rate). Companies opt for this type of swap to reduce the floating interest rate applicable to them and receive higher variable interest payments. It also helps to extend the maturity date of loans.
n Fixed-for-fixed rate swap: This swap is used only when both parties are dealing in different currencies and involves exchange of interest payments carrying predetermined rates. This swap helps international companies benefit from lower interest rates available to domestic consumers and avoid currency conversion costs.
Generally, the two parties in an interest rate swap trades fixed-rate and variable-interest rate. For example, one company may have a bond that pays the London Interbank Offered Rate (LIBOR), while the other party holds a bond that provides a fixed payment of 5 per cent. If the LIBOR is expected to stay around 3 per cent, then the contract would likely explain that the party paying the varying interest rate will pay LIBOR plus 2 per cent. That way both parties can expect to receive similar payments. The primary investment is never traded, but the parties will agree on a base value to use to calculate the cash flows that they'll exchange.
The theory is that one party gets to hedge the risk associated with their security offering a floating interest rate, while the other can take advantage of the potential reward while holding a more conservative asset. The gain one party receives through the swap will be equal to the loss of the other party.
To illustrate how interest rate swap works, let assume that an ABC group of companies is availing Tk. 1.0 billion of loans from different banks for which it has pay off floating interest quarterly on basis of LIBOR + 10 per cent. ABC group anticipates a rise of floating rate in the next one year and enters into an agreement with a bank for interest rate swap for three years. The bank agrees to make yearly payment of the notional principal of Tk.1.0 billion at 10.55 per cent annually. In such transaction, the bank actually swaps 10.55 per cent interest in exchange of LIBOR + 10% floating rate. As charted below, the LIBOR + 10 per cent floating rate does not end up more than the bank-accepted and ABC group won out a net gain of Tk. 8,27,000.
Banks need to have their revenue streams match their liabilities. For example, if a bank is paying a floating rate on its liabilities but receives a fixed payment on the loans it paid out, it may face significant risks if the floating rate liabilities increase significantly. As a result, the bank may choose to hedge against this risk by swapping the fixed payments it receives from their loans for a floating rate payment that is higher than the floating rate payment it needs to pay out. Effectively, this bank will have guarantee that its revenue will be greater than its expenses and therefore will not find itself in a cash flow crunch.
Companies can sometimes receive either a fixed- or floating-rate loan at a better rate than most other borrowers. However, that may not be the kind of financing they are looking for in a particular situation. A company may, for example, have access to a loan with a 5 per cent rate when the current rate is about 6 per cent. But they may need a loan that charges a floating rate payment. If another company, meanwhile, can gain from receiving a floating rate interest loan, but is required to take a loan that obligates them to make fixed payments, then two companies could conduct a swap, where they would both be able to fulfil their respective preferences.
One party is almost always going to come out ahead in a swap, and the other will lose money. The party that is obligated to making floating rate payments will profit when the variable rate decreases, but lose when the rate goes up and vice versa.
Apart from interest rate swaps, currency swaps and commodity swaps can play a big role in reforming and developing financial and money market of Bangladesh. After series of untoward incidents in banking sector and capital market, there is dearth of confidence among investors and savers' groups.
The Bangladesh Securities and Exchange Commission's circular on June 20, 2016 on financial derivatives has enabled a trading platform for participants for mobilising derivatives which would eventually engage heterogeneous investors and contribute to the national economy.
The writer is a financial services professional.
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