The Disadvantages of Interest Rate Swaps

by Walter Johnson

An interest rate swap is not that much different than a commodity future. In all cases, these kinds of bets are trying to predict the future interest rates -- or prices in general -- and invest in anticipation of them. If one firm has access to lower-cost funds than another, the disadvantaged firm will seek to swap rates so as to avoid rising rate problems. Normally, swaps are used to “lock in” a solid fixed rate in an uncertain market. Each party pays the other the difference between the fixed and floating rates in hopes of saving money on interest payments.

The Gamble

All forms of interest rate swaps are based on a bet. In fact, all investing itself is based on betting, albeit educated gambling. If a firm wants to lock in a fairly low rate in an uncertain market, then it might go to another market where rates are slightly higher, but stable. Therefore, the main risk is that the opportunity for savings might be lost.

Opportunity Risk

Opportunity cost when dealing with bonds is when a contract for the long term forces your money to be tied up when positive developments occur elsewhere. If you are worried about your variable-rate loan and seek to swap it with a more stable fixed rate in another market, you will lose if your local rate goes down. The swap, in general terms, is for conservative investors who are willing to take a slightly higher rate for the sake of stability. The bet, of course, is that the variable rates will go up.

The Long Term

The issue in interest rate swaps has been the problems involved with long-term lending. Beginning in the early 1980s, the swap market developed because the recessions of the 1970s forced many banks to become very wary about long-term commitments. This meant that investors needed to go to other markets to get long-term rates. These investors might get more expensive money, but they were locked into a tolerable rate for the long term. The only problem was that if the variable part of that swap was to fall, you would lose. In both cases, the two contracting parties want to save money on their obligations.

Credit Risk

Interest rate swaps developed because variable-rate loans for the long term were nerve-wracking. Conservative investors did not like them. Therefore, it was in their interest to pay a bit more for security. Other investors were quite willing to bet on interest rate changes that meant they would owe less on their obligations. The swap was then invented, and it became a market in 1982. One important disadvantage in addition to the opportunity risk was the fact that you were betting on the creditworthiness of your co-contractor. If he defaults, then your loan becomes more expensive. In other words, if your partner in the swap sees his loan become unacceptablly expensive, default might be an option, meaning that you no longer get the benefit of the swap, even if things go your way. You will no longer get the "swapped" payment from the other party.

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