One of the most common financial products used by credit unions for hedging interest rate risk is an interest rate swap. According to the Bank for International Settlements, as of 12/31/2019 the total notional amount outstanding of interest rate swaps exceeded $341 trillion. The most common type of interest rate swap, and what is typically used by credit unions, is a plain vanilla interest rate swap. In this form of interest rate swap, two parties (a credit union and a large commercial bank) enter into a contract where they agree to exchange fixed payments for floating payments linked to an interest rate index. Interest rate indices for the floating payments that are most commonly affiliated with interest rate swaps are:
Swaps are either traded over-the-counter (OTC) or on an exchange, with the vast majority being OTC. OTC simply means that the contract is between two parties – a swap dealer (large commercial bank) and the interest rate hedger (credit Union) – with no intermediary.
Below is a simple diagram of a plain vanilla interest rate swap:
The fixed rate is referred to as the swap rate. It is the fixed rate that the receiver requires in exchange for the uncertainty of paying a floating rate. The floating rate would be one of the interest rate indices listed above.
The amount, or size, of the swap is referred to as the notional amount. This amount is the predetermined dollar amount used in the calculation to determine the respective payment amounts. The notional amount never changes hands in the swap transactions, which is why it is considered notional, or theoretical. Only the swap fixed and floating settlement payments are exchanged. The payments are typically scheduled to occur simultaneously, and are netted from each other resulting in one net-payment per period – either paid to the dealer or received from the dealer.
Many credit unions fund long-term fixed-rate assets with short-term liabilities. Credit unions with this profile experience an earnings “squeeze” when short-term interest rates go up causing their cost of borrowing to rise faster than the yield on their long-term assets. To hedge this risk, credit unions can effectively “lengthen the maturity” on their funding with an interest rate swap. This has the effect of better matching the credit union’s funding costs to the yield on their long-term assets. Below is a diagram of an interest rate swap that achieves this outcome.
While interest rate swaps are an effective and commonly used interest risk management tool, there are advantages and disadvantages with interest rate swaps that should be understood and evaluated prior to deploying them in an interest rate risk management strategy. The follow-on article to this article will discuss those advantages and disadvantages.