Interest Rate Swaps

Abstract

“The standard textbook explanation shows how two corporate counterparties of differing credit quality can swap fixed for floating interest payments and both end up ahead. But this explanation only provides a range, not a specific value, for the equilibrium swap rate, based on rate spreads in the corporate market. In this article, Klein argues that much of the ambiguity arises because the role of the swap market maker in the transaction is ignored. Most swaps are not done directly between two corporate counterparties, but as two separate transactions with a market maker in the middle. There is often with a time delay, as well, during which the market maker warehouses the swap. In a competitive swap market, equilibrium swap rates will be determined by the rates the marginal market maker pays on fixed and floating rate liabilities. Klein provides empirical evidence to support the argument, using data from the Canadian market, in which the marginal market maker can be clearly identified as a large bank. Regression results show that swap rates are more closely related to bank spreads than to either corporate bond spreads or to Treasury rates.”