Why use an interest rate swap and how does it work?

It seems like only yesterday that I started my treasury career at one of NZ’s leading treasury advisory consultants, alas it was closer to 15 years ago. “We advise clients on managing their fx and interest rate exposures”, they said. “We use derivatives such as interest rate swaps to hedge risk”, they said. “Eh?”, I thought!

The financial markets have a lot of jargon but one quickly learns that many of the underlying concepts are quite simple. It is easy to assume people in the finance industry have a more in depth understanding of financial products than they actually do. There are plenty of examples of people who are exposed to interest rate swaps but whose understanding is rudimentary. Examples are young auditors who are coming across financial instruments rarely, or the back office clerk who is settling cashflows. Quite frankly there are also plenty of senior people who one might reasonably expect to have a greater level of understanding of these financial products than they actually do, such as senior auditors and CFOs.

In this article I attempt to explain in simple terms the purpose of an interest rate swap and how it works.

Why use an interest rate swap? When I was first learning about IRSs it was explained to me that they were simply an exchange of cashflows, either fixed for floating or floating for fixed, to hedge interest rate risk. Might as well have been in French for all it meant to me at the time. So I will try and take a step back. To my mind the best way to understand an IRS is by way of an example and the easiest example is that of a borrower who wishes to fix his interest rate exposure. Many of us borrow money from the bank in the form of a mortgage for our home and we choose to lock in the certainty of the interest rate payments by way of fixing the interest rate for a few years. A pretty simple concept. The corporate borrower has a few more options available to them to achieve certainty over interest costs on borrowings. They could borrow on a fixed rate basis very much akin to our residential mortgages. Alternatively, the corporate borrower could borrow from the bank on a floating rate basis and then enter a pay fixed interest rate swap to lock in the interest rate. The outcome is the same, however, the advantage of the IRS is the flexibility it allows the borrower in regards to the term he or she can fix and the flexibility to restructure. In terms of tenor, it is common for a borrower to fix through the IRS market out to ten years or longer. It is much harder, and expensive, to get the bank to fix interest rates long term as the bank needs to be compensated for tying up capital for such an extended period of time. It is also much harder, and expensive, to break debt that has been borrowed on a fixed rate basis, however, restructuring an IRS is a straightforward process and allows the corporate borrower to take advantage of prevailing interest rate market opportunities or “play the yield curve” to use financial market parlance.

How does an IRS work? Explaining how an IRS works requires us to understand the concept of exchanging cashflows. The diagram below represents the cashflows associated with a borrower using an IRS to fix interest costs:

IRS cashflow

 

1) The company borrows money from the bank, say $1 million for our example, on a floating rate basis. There are floating rate benchmarks for different currencies i.e. BKBM in NZ, BBSW in Australia, EURIBOR in Europe, etc. and this floating rate changes/sets every day. The bank will charge a margin on the money it lends, say 2.00%. The effect for the company is it borrows money at floating rate + 2.00%.

2) The company wishes to fix his interest cost and to achieve this enters a pay fixed / receive floating IRS with a bank (maybe the same bank as it has borrowed from, but not necessarily). We will assume the company wishes to fix the entire $1 million i.e. the swap is entered for $1 million. It could just as easily decide to fix only half i.e. $500,000. Herein lies some of the flexibility an IRS allows the company when considering its interest rate risk management profile. Under the terms of the pay fixed swap the borrower will pay the bank a fixed interest rate and receive floating interest from the bank i.e. exchange of cashflows. Note, there is no exchange of principal, only interest.

The floating rate received through the swap offsets the floating rate paid to the bank for the debt. The net impact to the borrower is paying a fixed rate (through the swap) plus the margin the bank charges for borrowing the money (2.00%).

There are some important factors to consider when entering an IRS to ensure the hedge is at its most optimal. The roll-dates of the IRS should match that of the debt i.e. if the floating rate on the debt sets every three months then so should the floating rate on the IRS, and on the same day. The underlying reference rate on the debt and the swap should also match i.e. BKBM, BBSW, EURIBOR, etc. Both of these things ensure there is no “basis risk” within the hedge as well as ensuring it passes muster from a hedge accounting perspective if it is designated into a hedge relationship.

The example above is designed to provide a basic understanding of the concept of an interest rate swap. We have used the floating rate borrower as an example. However, IRSs are used by an array of market participants for a multitude of uses including investors wishing to structure their income profiles or borrowers who have borrowed on a fixed term but wish to have exposure to floating interest rates. However, the underlying concepts are fairly straightforward.

 

Lies, damned lies and valuations

With the passing of 30 June we have entered another busy period for year-end valuations. One of the most common questions we are asked at these important balance dates is “why is there a difference between the bank valuation and the Hedgebook valuation (or any other system’s valuation for that matter)?” The question is most commonly posed by auditors. It is probably not surprising that auditors want a perfect reconciliation between the client’s information and their own independent check but alas it will never come to pass. In this article we consider a selection of reasons that can lead to differences in valuations.

Although the modelling of interest rate swap valuations is relatively unchanged over many, many years there are subtle differences that will result in no two valuations being the same. From an interest rate swap perspective the most likely source of valuation differences is the construction of the zero curve. The zero curve is used to estimate the future cashflows of the floating leg of the swap, as well as the discount factors used to net present value the future values of the cashflows (both fixed and floating legs).

The underlying interest rate inputs into the zero curve construction (deposit rates, bank bills, LIBOR, futures, swap rates, etc.) may be slightly different between one system and another. Unlike official rate-sets such as BKBM, BBSW, LIBOR, EURIBOR, CDOR, etc. there is no one source for zero curves.

The mathematical technique to combine the various inputs into a zero curve can also differ (linear interpolation, cubic spline). These types of differences can lead to discrepancies between one valuation and another. Although on a percentage of notional basis the discrepancies are small, the monetary differences can become material if the notional of the swap is big enough i.e. a $500 difference on a $1 million interest rate swap becomes a $50,000 difference on a $100 million swap – a number that will draw attention but in reality is still immaterial.

The timing of the market snapshot for closing rates can be different, too. For example, Hedgebook uses New York 5pm as the end of day for valuation purposes, therefore, if the Hedgebook valuation is compared to a system that uses, say, Australia 5pm as its rate feed, then any movement in the intervening period will cause differences in valuations.

What we have talked about above is premised on the fact that two identical deals are being valued against each other. By far the most common reason for different valuations lies in human error around the inputting of a deal. From an interest rate swap perspective, the rate-set frequency (monthly, quarterly), accrual basis, business day conventions, margins on the floating leg are all possible areas which can result in valuation differences. The most common input error we come across relates to amortising interest rate swaps (changing face value and/or interest rate over the life of the swap). Very often there is no way for an auditor to realise that a swap is an amortising structure just by looking at the bank valuation. Often it is just the face value of the swap at the current valuation date that is shown on the bank valuation. It is the schedule at the end of the original bank confirmation that is required to accurately input and value such a structure.

Of course the true valuation of a derivative is determined by the price at which it can be sold/closed out which will be different to a valuation for accounting purposes. Valuations for accounting purposes are based on mid rates and, therefore, take no account of bid/offer spreads. Some of the changes we are seeing in the International Financial Reporting Standards are trying to provide greater consistency and more explicit definitions of fair value (IFRS 13). At least the “risk-free” component of an interest rate swap is a well-established methodology. The same cannot be said for the credit component (CVA), for which there is a myriad of approaches. It will be interesting to see how differences are reconciled and treated by auditors, as there is even less likelihood of two valuations being the same.

End of year derivative valuations improve for borrowers

The increase in interest rates over 2013 means that the 31 December 2013 valuations of borrower derivatives such as interest rate swaps will look much healthier compared to a year ago. The global economy certainly appears to have turned a corner through 2013 and this is being reflected in financial markets expectations for future interest rates i.e. yield curves are higher. As interest rates collapsed after the onset of the GFC many borrowers took advantage of what were, at the time, historically low levels. Base interest rates i.e. ignoring credit, were compelling and borrowers increased their fixed rate hedging percentages locking in swap rates for terms out to ten years. Unfortunately, as the global economy sank further into recession, interest rates fell further than most market participants expected. Consequently, derivatives such as interest rate swaps moved further out-of-the-money creating large negative mark-to-market positions.

The unprecedented steps taken by central banks in an effort to shore up business and consumer confidence, protect/create jobs and jump start lack lustre economies pushed interest rates lower for much longer. Through 2013 the aggressive monetary policy easing undertaken since 2008 (by the US in particular) has started to show signs that the worst of the Great Recession is behind us. The Quantitative Easing experiment from the US Federal Reserve’s Chairman Ben Bernanke appears to be a success (only time will confirm this). The labour market has strengthened, as well as GDP, in 2013 allowing a gradual reduction in Quantitative Easing to begin. Although the US Central Bank has been at pains to point out that the scaling back of QE does not equate to monetary policy tightening, merely marginally “less loose”,           the financial markets were very quick to reverse the ultra low yields that had prevailed since 2008.   The US 10-year treasury yield is the benchmark that drives long end yields across every other country so when bond markets in the US started to aggressively sell bond positions, prices dropped and yields increased globally. As the charts below show all the major economies of the world now have a higher/steeper yield curve than they did a year ago reflecting expectations for the outlook for interest rates. For existing borrower derivative positions the negative mark-to-markets that have prevailed for so long are either much less out-of-the-money, or are moving into positive mark-to-market territory.

Of the seven currencies that are included in the charts below, all display increases in the mid to long end of the curve i.e. three years and beyond, to varying degrees. Japan continues to struggle having been in an economic stalemate for 15-years so the upward movement in interest rates has been muted. The other interesting point is the Australian yield curve which shows that yields at the short end are actually lower at the end of the year than they were at the start of the year. Australia managed to avoid recession after the GFC, a beneficiary of the massive stimulus undertaken by China and the ensuing demand for Australia’s hard commodities. However, as China’s economy subsequently slowed and commodity prices fell, the recession finally caught up with Australia and the Official Cash Rate (OCR) has been slashed in 2013, hence short-term rates are lower than where they started the year.

As 31 December 2013 Financial Statements are completed there will be many CFOs relieved to see the turning of the tide in regards to the revaluation of borrower derivatives.

2012 to 2013 yield curve movements

It’s risk management stupid

The bankrupted City of Detroit is locked in a legal battle over the purchase of interest rate swaps as are many other municipalities/local governments around the world. Detroit’s case is particularly high profile given the tragic demise of a once great city, and as with most bankruptcies not everyone appears to be treated equally or indeed fairly.

The numbers that relate to the interest rate swaps are enormous, which is no doubt why Detroit feels so aggrieved. These numbers are also, not surprisingly, losses, and indeed realised losses as the bankruptcy will result in the closing out of these swaps. But whose fault is it really, the banks for selling these swaps or the municipality for purchasing them?

Everyone likes to bash the banks and indeed they may not be blameless in this case. If the banks are withholding information or forcing the entity into purchasing the swaps as part of the underlying transaction then this doesn’t seem right. However, whether you are a large municipality in the US or a dairy farmer in New Zealand the onus is on the buyer of these products to understand the risks associated with them before they transact. It is difficult to believe that a finance team that is sophisticated enough to issue millions of dollars of bonds does not understand the mechanics of an interest rate swap.

Interest rate swaps are risk management tools. They can be used to give certainty of interest cashflows for entities that are perhaps highly geared and therefore cannot afford to pay any higher interest rates or can also be used as a proactive way of managing interest rates. Portfolio management dictates that a proportion of debt should be fixed either through fixed rate borrowing or interest rate swaps but the financial markets are not a one way bet, otherwise we would all be millionaires. There are risks attached to entering these transactions. As is often the case we hear of the cases where rates have gone against the swap owner but not so much when it has gone the other way.

Interest rate swaps are not toxic or necessarily dangerous. They should though be used by those who understand them. The various scenarios that can play out depending on movements in the financial markets should be modelled. Interest rate swaps also have the flexibility of being able to be closed out as part of the overall risk management strategy if necessary.

As with any purchase the buyer needs to know what they are buying. With swaps they need to form part of the overall risk management approach. We would all like the opportunity to try and renegotiate the whys and wherefores of entering into a financial instrument when the markets move against us. Swaps can be complicated but are also useful risk management tools that have a place in any borrowers or investors risk management strategy. Lack of understanding should not be a defense against decisions which in hindsight may not have been made.

IFRS 13: Fair value measurement – Credit Value Adjustment

The purpose of this blog is to examine IFRS 13 as it relates to the Credit Value Adjustment (CVA) of a financial instrument. In the post GFC environment, greater focus has been given to the impact of counterparty credit risk. IFRS 13 requires the valuation of counterparty credit risk to be quantified and separated from the risk-free valuation of the financial instrument. There are two broad methodologies that can be considered for calculating CVA: simple and complex. For a number of pragmatic reasons, when considering the appropriate methodology for corporates, the preference is for a simple methodology to be used, the rationale for which is set out below.

IFRS 13 objectives

Before considering CVA it is worthwhile re-capping the objectives of IFRS 13. The objectives are to provide:

–          greater clarity on the definition of fair value

–          the framework for measuring fair value

–          the disclosures required about fair value measurements.

Importantly, from a CVA perspective, IFRS 13 requires the fair value of a liability/asset to take into account the effect of credit risk, including an entity’s own credit risk. The notion of counterparty credit risk is defined by the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement.

Factors that influence credit risk

When considering credit risk there are a number of factors that can influence the valuation including:

–          time: the longer to the maturity date the greater the risk of default

–          the instrument: a forward exchange contract or a vanilla interest rate swap will carry less credit risk than a cross currency swap due to the exchange of principal at maturity

–          collateral: if collateral is posted over the life of a financial instrument then counterparty credit risk is reduced

–          netting: if counterparty credit risk can be netted through a netting arrangement with the counterparty i.e. out-of-the money valuations are netted with in-the-money valuations overall exposure is reduced

CVA calculation: simple versus complex

There are two generally accepted methodologies when considering the calculation of CVA with each having advantages and disadvantages.

The simple methodology is a current exposure model whereby the Net Present Value (NPV) of the future cashflows of the financial instrument on a risk-free basis is compared to the NPV following the inclusion of a credit spread. The difference between the two NPVs is CVA.  The zero curve for discounting purposes is simply shifted by an appropriate credit spread such as that implied by observable credit default swaps.

Zero curve

To give a sense of materiality, a NZD10 million swap at a pay fixed rate of 4.00% with five years to maturity has a positive mark-to-market of +NZD250,215 based on the risk-free zero curve (swaps). Using a 200 basis point spread to represent the credit quality of the bank/counterparty the mark-to-market reduces to +NZD232,377. The difference of -NZD17,838 is the CVA adjustment. The difference expressed in annual basis point terms is approximately 3.5 bp i.e. relatively immaterial. In the example we have used an arbitrary +200 bp as the credit spread used to shift the zero curve. In reality the observable credit default swap market for the counterparty at valuation date would be used.

The advantages of the simple methodology is it is easy to calculate and easy to explain/demonstrate. The disadvantage of the simple methodology is takes no account of volatility or that a position can move between being an asset and a liability as determined by the outlook for interest rates/foreign exchange.

The complex methodology is a potential future exposure model and takes account of factors such as volatility (i.e. what the instrument may be worth in the future through Monte Carlo simulation), likelihood of counterparty defaulting (default probability) and how much may be recovered in the event of default (recovery rate). The models used under a complex methodology are by their nature harder to explain, harder to understand and less transparent (black box). Arguably the complex methodology is unnecessary for “less sophisticated” market participants such as corporate borrowers using vanilla products, but more appropriate for market participants such as banks.

Fit for purpose

An important consideration of the appropriate methodology is the nature of the reporting entity. For example, a small to medium sized corporate with a portfolio of vanilla interest rate swaps or Forward Exchange Contracts (FECs) should not require the same level of sophistication in calculating CVA as a large organisation that is funding in overseas markets and entering complex derivatives such as cross currency swaps. Cross currency swaps are a credit intensive instrument and as such the CVA component can be material.

Valuation techniques

Fair value measurement requires an entity to explain the appropriate valuation techniques used to measure fair value. The valuation techniques used should maximise the use of relevant observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability. In other words, the reporting entity needs to be able to explain the models and inputs/assumptions used to calculate the fair value of a financial instrument including the CVA component. Explaining the valuations of derivatives including the CVA component is not a straightforward process, however, it is relatively easier under the simple methodology.

Summary

IFRS 13 requires financial instruments to be fair valued and provides much greater guidance on definitions, frameworks and disclosures. There is a requirement to calculate the credit component of a financial instrument and two generally accepted methodologies are available. For market participants such as banks, or sophisticated borrowers funding offshore and using cross currency swaps, there is a strong argument for applying the complex methodology. However, for the less sophisticated user of financial instruments such as borrowers using vanilla interest rate swaps or FECs then an easily explainable methodology that simply discounts future cashflows using a zero curve that is shifted by an appropriate margin that represents the counterparty’s credit should suffice.

Credit Value Adjustment

Credit Value Adjustment or CVA has been around for a long time, however, with the introduction of the accounting standard IFRS13, this year there is a requirement to understand it a bit better. The new standard requires the CVA component to be separately reported from the fair value of a financial instrument.

CVA is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

The big question is whether it will be material enough for most organizations to worry about; given the potential complexity around its calculation, most would hope not.

There is no doubt if you have cross-currency swaps the impact of CVA is likely to be material. However most companies that use these instruments would normally have a sophisticated treasury management system that would do this calculation at the push of a button.

Most other organizations however will probably be relying on spreadsheets to capture and record their treasury transactions and will lack the ability to calculate financial instrument valuations let alone the more complex CVA.

Will you need to worry about CVA is the question? Most do not know there is a requirement, let alone how it will be calculated and this is true of the audit profession as much as the corporate world.

Whether it is material or not may be the question, however, it is likely that even if it is not material there may be a requirement to prove this. At the end of the day the audit profession will decide whether organizations will need to calculate CVA or not. In the meantime we are keeping a watching brief on both the banks’ ability to provide the CVA component and the audit firms as to whether they will force organizations to calculate it.

Watch this space.

Hedging Basics: Swaptions

Interest rate options are excellent tools to use to mitigate interest rate exposure.  One robust structure that is used to reduce exposure to monthly periods of interest rate volatility is the interest rate swaption.  This instrument combines the protection of a swap, with the flexibility of a European style option.

Interest Rate Swap
An interest rate swap is a fixed for floating swap which allows an investor or corporate treasurer to reduce their exposure to interest rates by selling or buying a swap.  A pay fixed swap reduces exposure to climbing interest rates while a pay float swap reduces exposure to declining interest rates.

European Option
A European style option is an option in which the purchaser of the option can only exercise the option on the expiration date.  The option is the right but not the obligation to purchase a financial instrument as a specific date in the future.  The strike price is the price at which the buyer and seller of the option agree to buy/sell the financial product.

Interest Rate Swaption
An interest rate Swaption is the right but not the obligation to purchase an interest rate swap on a specific date.  On the expiration date, the owner of the swaption has the right to purchase the swap at the strike price.  A swaption payout profile is similar to a European option.

Where do Swaps Fit into Your Company’s Portfolio?

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.

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 myHedgebook, 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.

Try Hedgebook free for 30 days. Click here to start your trial today!

The Future of Interest Rate Swaps: Will Regulation Kill this Investment Vehicle?

This is part 9 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 8, we discussed the role of interest rate swaps in the demise of Greece. Given the importance of swaps in the U.S. housing crash, new regulation has arisen that could threaten the future of this important financial derivative.

In late-2008, financial markets were a mess: credit markets had dried up; equity markets plummeted, eliminating trillions of dollars of wealth from the economy; and politicians needed someone to blame. Given the fact that a series of complex transactions involving swaps ultimately accentuated the market crash, OTC derivatives, specifically swaps, were an easy target.

With public outcry high for a scapegoat, U.S. Congressmen and Congresswomen called for action to regulate OTC derivatives, what the Bank of International Settlements has characterized as a $415.2 trillion market. Led by House Financial Services Committee Chairman Barney Frank, new regulations were set forth in December 2009 to curb risk tanking by large financial institutions. Regulations focused on two main issues:

  1. Should financial institutions have ownership in swaps clearinghouses? Should ownership be limited? A conflict of interest may arise provoking riskier activities if not addressed properly.
  2. Should regulators have the power to set capital and margin requirements for non-financial participants in the swaps market? Would this regulation result in lower market participation rates, thus creating a premium for liquidity?

When the Dodd-Frank Act (named after Senator Christopher Dodd and Representative Barney Frank, the chief architects) was signed into law by President Barack Obama in July 2010, many of the large financial institutions operating within the OTC market were forced to sell off operations involving swaps deemed uncritical to their in-house hedging operations; or the arms of the financial institutions trading in swaps markets for speculative purposes were forced to close. Additionally, OTC derivatives trading would be funneled through clearinghouses and exchanges for greater accountability.

Financial Scholars Group published perhaps the best perspective on the Dodd-Frank Act in July 2012:

Dodd-Frank legislation was passed in 2010 to overhaul the financial market with the objective of removing or alleviating systemic deficiencies. With respect to OTC IR swaps, Dodd-Frank seeks to lower systemic risk through centralized clearing of trades, better risk management, and trade reporting transparency. Yet despite its size, the IR swap market is small in important respects. Any policy attempting to address a market hundreds of trillions of dollars in size must also take into account that in some ways the swap market is quite nuanced, with some IR swaps trading very thinly and thus potentially substantially disrupted by even finely tuned regulatory policies.

FSG continued to say, “In thin markets disclosing deal terms can have the opposite effect. This is because statistical data is no longer anonymous. With a small number of trades, parties can potentially make inferences about the investment strategies of others. Thus, trade data for thin markets can have an undesirable, amplified signaling effect revealing the market expectations of some participants.”

Given these observations, we can draw a few necessary conclusions: first, OTC derivatives markets, especially those related to swaps, are under a microscope, especially in the United States. Second, a fundamental lack of understanding by legislators could lead to overregulation, diminishing the effectiveness of interest rate swaps (and other variations of swaps) as hedges.

Over the next few years, it is unlikely that regulation comes down hard on the OTC derivatives market barring a major financial crash with swaps at the center once more. This is a far-fetched outcome going forward, considering that loose monetary policies across the globe have introduced trillions of dollars of liquidity over the past few years, driving down borrowing rates in both developed and developing economies. As such, and in light of the increased globalized nature of financial markets in contemporary times, swaps will remain an important financial instrument for years to come.

In part 10 of 10 of this series, we’ll talk about the role of swaps in your company’s hedge portfolio and why, despite the bad rap they get from the U.S. housing crisis, the Goldman Sachs-Greece debacle, and political posturing, swaps remain an integral and important part of global financial markets

The Euro-zone Crisis: Goldman Sachs, Greece, and Swaps

This is part 8 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 8, we’ll discuss the role of swaps in more recent times: the Euro-zone crisis.

In June 2001, seeking to shore up its finances as it prepared to use the Euro as a member of the Euro-zone currency union, Greece reached a deal with the U.S. bank Goldman Sachs to borrow €2.8 billion.  When the deal was reached, the Greek government had already owed Goldman Sachs about €600 million – not counting the €2.8 it just borrowed.

Just four years later, the costly transaction nearly doubled to €5.1 billion. It turns out that a currency swap agreement was in place to help conceal Greece’s haphazardly constructed balance sheet, which showed that the country was experiencing an unsustainable rise in its debt-to-GDP ratio. Without the deal, Greece wouldn’t have been able to join the Euro-zone, as its debt-to-GDP ratio was in breach of the European Union’s rules for the amount of debt each country could have in order to join the Euro. But a loophole in the law allowed the currency swap agreement in place to not be counted as debt, thereby keeping Greece’s debt-to-GDP ratio within the European Union’s required range.

The arrangement made in June 2011 had two key components. The first was a series of currency swaps. Greece’s debt, which historically was accounted for in Japanese Yen and U.S. Dollars, was converted to Euros for the transition into the common market. Instead of the contracts being transacted at the spot exchange rate, they were measured against a fake exchange rate devised by the Greek government and Goldman Sachs – a perfectly legal move, given accounting rules in the European Union at the time.

Because of the positive value that currency swaps had for Greece, the government needed to pay back what was, for all intents and purposes, a loan from Goldman Sachs. In a separate deal, Greece entered into an interest rate swap which yielded a positive value of €2.8 billion to Goldman Sachs, including €400 million in fees for unwinding other swaps Greece had entered. In its truest sense, this was a fixed-for-floating swap: Greece would send floating-rate payments to Goldman until 2019, while Goldman Sachs would happily send fixed-rate payments to Greece.

Perhaps the best analogy for what happened to Greece is what happened with the U.S. housing crisis. Part of the deal with Goldman Sachs was a two-year period in which Greece would not have to make any payments, similar to what is the teaser rate period. As history showed, without the benefit of rising housing prices, subprime borrowers couldn’t refinance within the teaser window (in which rates were low before springing to unsustainably high levels, hence the housing crash).

Like the teaser loan rates enjoyed by subprime borrowers in the U.S., the payment-free period enjoyed by Greece made it seem like the country’s finances were fine, because the country didn’t have any debt obligations for two-years. Instead of hoping for rising house prices, the Greek government was hoping that an economic boom would spur higher tax receipts, which the government could use to pay down the cost of the currency swap.

While the Greek government enjoyed low borrowing costs, the repercussions were building on the horizon: the deferred interest would have to be paid eventually. In 2005, as noted earlier, Greece was forced to refinance the loan, bringing the total cost of the deal to €5.1 billion. This “actively managed tweak,” as described by Eurostat, allowed Greece to keep the loan a secret, thereby keeping its debt-to-GDP ratio within the European Union’s mandated range. After Greece refinanced its debt, Goldman Sachs sold its obligation to the National Bank of Greece, at a marked-to-market value of €5.1 billion.

But these are just large numbers – why do they actually matter? When Greece initiated the original transaction with Goldman Sachs, it had publicly issued 10-year bonds with a coupon rate of 5.35%. Some quick math: compounding this rate over four years (to 2005), Greece would have owed €3.4 billion; instead, the €5.1 billion obligation represented an astounding 16.3% (!) annual interest rate.

Instead of bringing this issue to light immediately, the government chose to hide the mistake further, extending the maturity of the loan another 18 years to 2037. But by 2010, the costly repayments were too much to handle, and Greece was forced to reinstate the debt onto its balance sheet: the Greek debt crisis was born. Today, it is widely expected that Greece will default on its >€300 billion of obligations, forcing it out of the Euro-zone and back to using the Drachma, Greece’s pre-Euro currency.

In part 9 of 10 of this series, we’ll discuss recent regulatory efforts as a direct result of costly mistakes that have piled up over the past several years directly related to swaps.