Swaps Trading Is Changing Due to New Technologies and Processes
Trading in swap contracts have been significantly impacted as a result of the recent changes in market trading and have changed as a result of these changes. Swap contracts have recently growing in popularity due to an increased sophistication on the part of borrowers, as well as due to all time lows on interest rates that many organizations are attempting to lock in.
Swap contracts are often used as a way to lock in a fixed rate of interest on outstanding loans. Some loans taken by businesses are based upon a variable rate. The interest rate on these loans will fluctuate based upon a change in some other factor, usually a central bank rate or interbank lending rate. An example is a loan based upon the London Interbank Offering Rate, which is the rate charged between banks for loans. Many variable interest rate loans are based upon the Libor rate plus 2% or a higher interest rate for the additional risk taken on loaning money to this specific loan.
Businesses do not like the uncertainty that comes with a variable interest rate. As a result, they often fix the interest rate associated with these loans by transferring all or a portion of the rate on these loans with a swap contract. Effectively, the Company trades the variable interest rate for a fixed rate. The company may benefit or lose out on this swap agreement.
Swaps trading is increasingly complicated and this serves as only an introduction to these securities. As a result, swaps trading is difficult to account for and more difficult to hedge. New technologies and processes are involved with the valuing of these swap contracts which improve the valuation process. In addition, additional attention is being paid to how these swap contracts impact one another and a total perspective of the risk associated with viewing all of the swap agreements the company is in altogether.
Deciding to hedge and having effective hedges in regards to interest rate swaps are two different things. Properly executing a swap execution facility involves having a process in place to select, price, and determine the appropriate value and gain or loss on these instruments. Selecting and disposing of these swap contracts are also an important portion of swap execution facility. A firm should have a process in place for this in addition to a process in place for assessing the quality of this department.