Risks
Interest rate swaps expose users to interest rate risk and credit risk.
- Market Risk: A typical swap consists of two legs, one fixed, the other floating. The risks of these two component will naturally differ. Newcomers to market finance may think that the risky component is the floating leg, since the underlying interest rate floats, and hence, is unknown. This first impression is wrong. The risky component is in fact the fixed leg and it is very easy to see why this is so.
(Comment: the above comment is not entirely accurate. Normally people will assume a hypothetical notional exchange at the end. After this hypothetical assumption, the swap can be understood as a floating rate bond vs a fixed rate bond. The risks on the floating bond side are small compared to the risks from the fix rate bond side. However, without this hypothetical notional exchange at the end, purely the floating cash flow from the coupon payments will have higher risks than the cash flow from the fixed coupon payments. Both understanding have their merit and fully understand these two views are important to see the risks, particularly for floating floating swaps)
The discussion of pricing interest rate swaps illustrated an important point. Regardless of what happens to future Libor rates, the value of a rolling deposit or FRN always equals the notional amount N at the reset dates. Between the reset dates this value may be different than N, but the discrepancy cannot be very large since the δ will be 3 or 6 months. Interest rate fluctuations have minimal effect on the values of fixed instruments with such maturities. In other words, the value of the floating leg changes very little during the life of a swap.
On the other hand the fixed leg of a swap is equivalent to a coupon bond and fluctuations of the swap rate may have major effects on the value of the future fixed payments.
- Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party.
Read more about this topic: Interest Rate Swap
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