THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 403
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CHAPTER 14
Interest-Rate
Swap
Contracts
Risk Management with Financial Derivatives
371
Interest-rate swaps are an important tool for managing interest-rate risk, and they
first appeared in the United States in 1982 when there was an increase in the
demand for financial instruments that could be used to reduce interest-rate risk. The
most common type of interest-rate swap (called the plain vanilla swap) specifies
(1) the interest rate on the payments that are being exchanged; (2) the type of interest payments (variable or fixed-rate); (3) the amount of notional principal, which
is the amount on which the interest is being paid; and (4) the time period over
which the exchanges continue to be made. There are many other more complicated
versions of swaps, including forward swaps and swap options (called swaptions),
but here we will look only at the plain vanilla swap. Figure 14-4 illustrates an
interest-rate swap between First Trust and the Friendly Finance Company. First
Trust agrees to pay Friendly Finance a fixed rate of 7% on $1 million of notional
principal for the next ten years, and Friendly Finance agrees to pay First Trust the
one-year treasury bill rate plus 1% on $1 million of notional principal for the same
period. Thus, as shown in Figure 14-4, every year First Trust would be paying the
Friendly Finance Company 7% on $1 million while Friendly Finance would be paying First Trust the one-year T-bill rate plus 1% on $1 million.
Pays
First
Trust
Receives
F I G U R E 14 - 4
Fixed rate
over
ten-year period
7% $1 million
Variable rate
over
ten-year period
(T-bill 1%) $1 million
Receives
Friendly
Finance
Company
Pays
Interest-Rate Swap Payments
In this swap arrangement, with a notional principal of $1 million and a term of ten years, First
Trust pays a fixed rate of 7%
$1 million to the Friendly Finance Company, which in turn
agrees to pay the one-year treasury bill rate plus 1% $1 million to First Trust.
A PP LI CATI O N
Hedging with Interest-Rate Swaps
You might wonder why the managers of the two financial institutions find it advantageous to enter into this swap agreement. The answer is that it may help both of
them hedge interest-rate risk.
Suppose that First Trust, which tends to borrow short-term and then lend longterm in the mortgage market, has $1 million less of rate-sensitive assets than it has
of rate-sensitive liabilities. As we learned in Chapter 13, this situation means that as
interest rates rise, the rise in the cost of funds (liabilities) is greater than the rise in
interest payments it receives on its assets, many of which are fixed-rate. The result
of rising interest rates is thus a shrinking of First Trust s net interest margin and a
decline in its profitability. As we saw in Chapter 13, to avoid this interest-rate risk,
