In a plain vanilla interest rate swap, one counter party has an initial position in a fixed rate debut instrument, while the other counterparty has an initial position in a floating rate obligation. In this initial position, the party with the floating rate obligation is exposed to changes in intrest rates. By swapping this floating rate obligtion, the interest rate swap increases the interest rate sensitivity.
To see the nature of the plain vanilla interest rate swap most clearly, we use an example. We assume that the swap covers a five-bear period and involves annual payments on a $1 million principal amount. Let us assume that Party A agrees to pay a fixed rate of 12 percent to Party B. In return Party B agrees to pay a floating rate of LIBOR + 3 percent to Party A. Part A pays 12 percent of $1 million, or $120,000 each year to Party B. Party B makes a payment to Party A in return, but the actual amount of the payments depends on movement in LIBOR.
As an example of a prime candidate for an interest rate swap, consider a typical savings and loan association. Savings and loan associations accept deposits and lend those funds for long-term mortgages. Because depositors can withdraw their funds on short notice, deposit rates must adjust to changing interest rate conditions. Most morgagors wish to borrow at a fixed rate for a long time. As a result, the savings and loan association can be left with floating rate liabilities and fixed rate assets. This means that the savings and loan is vulnerable to rising rates. If rates rise, the savings and loan will be forced to increase the rate it pays on deposits, but it cannot increase the rate it charges on the martgages that have already been issued.
To escape this interest rate risk, the savings and loan might use the swaps market to transform its fixed rate assets into floating rate assets or transform its floating rate liabilities into fixed rate liabilities. Let us assume that the savings and loan wishes to transform a fixed rate mortgage into an asset that pays a floating rate of interest. In terms of our interest rate swap example, the savings and loan association is like Party A - in exchange for a fixed rate morgage that it holds, it wants to pay a fixed rate of interest and receive a floating rate of interest. Engaging in a swap as Party A did will help the association resolve its interest rate risk.
Futures, Options & Swaps, Second Edition, Robert W. Kolb, Blackwell Business, 1997
A swaps trader makes money by betting on the direction of interest rates (e.g., the difference between the short term rates and the long term rates). To quote Lowenstein:
The swap rate is, at any given moment, the fixed rate that banks, insurers, and other investors demand to be paid in exchange for agreeing to pay the LIBOR rate, a short-term bak rate. The twist is that the LIBOR rate floats; no one knows where it will go in the future. Typically, swap rates in each country trade at a slight spread above the interest rate on the country's government debt. Thus, this swap spread is a basic barometer of credit market anxiety; it is the premium that investors demand for taking the risk of being exposed to rate fluctuations in the future.
In the United State, in April 1998, the swap spread was 48 basic points [0.48 percent]. In recent historical terms, this number was high (it had been below 35 [basis] points for most of the 1990s, although, during the last recession, in 1990, it had briefly spurted to 84 [basis points]). Long-Term, seeing no recession on the horizon, had bet on this spread to narrow.
Equity volatility is the amount an underlying stock or group of stocks (like the S&P 500) changes in a given period of time. Equity volatility is one of the factors used in the pricing of stock options. LTCM made their own estimates of equity volatility and when these estimates differed from the volatility implied by the options market LTCM made "volatility bets", using customized options contracts.
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