Interest rate swaps

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Interest-rate swaps (IRSs) are private OTC derivatives contracts agreed between mostly large financial institutions and corporations, although the market for them froze recently following the credit crisis. IRS contracts allow participants to swap short-term cash flows from fixed income assets in the same currency. The spread between IRSs and short-term interbank rates in considered a key indicator of market sentiment.

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The most popular interest rate swaps are those exchanging fixed-rate debt securities for those with floating or variable interest rates or vice versa. The most common, called vanilla IRSs, use the floating 3-month or 6-month LIBOR interbank rate, while basis swaps exchange one floating interest rate for another.^[1] Hedgers can use interest-rate swaps top protect against declining or rising interest rates while speculators believing interest rates will rise can use IRSs to short sell fixed-income securities like bonds.

In late September 2008, in the midst of a debilitating freeze in global credit markets, the spread between a two-year interest-rate swap and two-year T-notes rose to a record level of 166.38 basis points.^[2]. Issuers of debt such as municipal bonds that held interest rate swaps with now-defunct Lehman Brothers were forced to liquidate their positions and replace their counterparties.

Latest news

The rates on Asian IRSs declined recently to its lowest in almost two years, a sign that banks in those countries will continue lowering interest rates into the foreseeable future.^[3] Asian central banks in countries from South Korea to Indonesia have already cut interest rates as inflation falls, with South Korea's 7-day repo rate recently falling 75 basis points to 4.25 percent while its swap rate fell recently to 4.66 percent.