Interest Rate Swaps (2024)

Summary:​

• Interest swap rates are agreements between two parties to exchange cash flows based on a predetermined fixed or floating interest rate.
• Swap rates allow banks, companies, and investors to manage interest rate risk by locking in a fixed interest rate for a specific period.
• Increasing swap rates can lead to higher floating interest rates for borrowers with floating-rate mortgages while decreasing swap rates can lead to lower floating interest rates.
  
• Interest rate swaps involve two primary risks;interest rate riskandcredit risk, but we believe credit risk is low in New Zealand given it is the banks that predominantly enter into swap contracts.
  
• The New Zealand 90-day bank bill rate is the benchmark rate for floating interest rate payments in New Zealand swap agreements.
• Swap rates can be used for various purposes, such as hedging against interest rate risk, managing cash flows, or speculating on interest rate movements. However, they're just one of many tools available for managing interest rate risk.
  

Our guide covers:

• How Interest Rate Swaps Work
• Understanding the Risks of Interest Rate Swaps
• Must-Know Facts About Swap Rates
• Frequently Asked Questions

How Interest Rate Swaps Work

A swap rate is anagreement between two partiesto exchange cash flows based on a predetermined fixed or floating interest rate. The parties involved in a swap agreement are called the "fixed-rate payer" and the "floating-rate payer." The fixed-rate payer agrees to pay a fixed interest rate to the floating-rate payer, who agrees to pay a floating interest rate based on a benchmark rate such as the New Zealand 90-day bank bill rate.

Theswap rate is the fixed interest ratethat the fixed-rate payer agrees to pay the floating-rate payer. The swap rate is calculated based on thedifference between the fixed interest rateand thefloating interest rateand theperiodover which the swap agreement will run.

For example, if Westpac has issued floating-rate loans to borrowers and then decides to convert the floating interest rate on the loan to a fixed interest rate, Westpac can enter into a swap agreement with another party (for example, ASB) to exchange the floating interest rate payments for fixed interest rate payments. The swap rate will be determined based on the difference between the floating interest rate and the fixed interest rate and the period over which the swap agreement will run.

Know This: Interest rate swaps first helped banks manage their floating-rate debt liabilities by allowing them to agree with other banks or counterparties to pay fixed rates and receive floating-rate payments. This meant that banks could pay a fixed interest rate but receive payments matching their floating-rate debt. But, of course, they could also do the opposite – pay floating rates and receive a fixed interest rate.

Swaps have now evolved to reflect the market's expectations for interest rates in the future; hence higher movements in swap rates reflect the possibility of increasing interest rates and vice versa. For this reason, they are closely watched by housing market commentators as a predictor of mortgage lending rates.

Why are Swap Rates Important?

• Swap rates are important in financial markets because they enable banks, companies, and investors tomanage interest rate risk. Interest rate risk is therisk that the value of a financial instrument will decline due to changes in interest rates. For example, if interest rates rise, the value of a fixed-rate bond will decline because the interest payments on the bond are fixed and do not increase with rising interest rates. Our guide to bonds and investing in New Zealand bonds explain more.
  
• Using swap rates, banks, companies, and investors canhedge against interest rate risk by locking in a fixed interest ratefor a specific period. This can help to stabilize their cash flows and protect them against interest rate volatility. Swap rates also play a critical role in pricing various financial instruments and are most popular in the mortgage market.

What do increasing and decreasing swap rates indicate for New Zealanders with mortgages?

What's the difference between the OCR and swap rates?

The overnight domestic cash (interest) rate, or OCR, is a key interest rate set by the Reserve Bank of New Zealand and directly affectsshort-term interest ratessuch asfloating home loan rates. As the bank for the banks, the Reserve Bank sets the OCR, the interest rate paid to banks for their deposits with the Reserve Bank, essentially the bank's interest income.

On the other hand, swap rates are the rates at which parties are willing toswap floating income for fixed income. These rates are particularly influential for longer-term home loan rates, such as thosefixed for one or more years.

To ensure they can match the maturity of their assets (loans out) with their liabilities (deposits in), banks use interest rate swap contracts to hedge future interest rate risk. For this reason, home loan rates are determined by swap rates, which are the prices banks pay to lend for longer maturities.

In summary, while the OCR significantly impacts short-term interest rates,swap rates play a crucial role in determining longer-term home loan rates, as they allow banks to manage their interest rate risk and ensure they can match the maturity of their assets with their liabilities.

Understanding the Risks of Interest Rate Swaps

There are two primary risks – interest rate risk and credit risk. Because the New Zealand interest rate market is predominantly interbank, the credit risk is arguably low.

• Understanding the interest rate risk: Interest rates move around, and it's not uncommon for banks to get their predictions wrong. This means the bank receiving fixed-rate interest will profit if interest rates fall and lose if interest rates rise. Conversely, the bank paying fixed-rate interest to the other bank will profit if interest rates rise and lose if interest rates fall.
  
• Understanding credit risk:This is the chance that either contracting party to an interest rate swap defaults on its responsibility to make payments. The risk is low given the capital reserves of New Zealand banks and the fact that the overall risk of interest rate swaps causing material losses to a bank is low.
  

Must-Know Facts About Swap Rates

Our list of facts is published to help explain interest rate swaps further:

1. The market forces of supply and demand determine swap rates. In addition, the swap rate reflects the expectations of market participants regarding future interest rate movements.
2. Swap rates are quoted in basis points. A basis point is equal to 0.01%, so a swap rate of 50 basis points is equal to 0.50%. Our basis points calculator explains more details.
3. The New Zealand 90-day bank bill rate is the benchmark rate for floating interest rate payments in New Zealand swap agreements.
4. The Reserve Bank of New Zealand (RBNZ) plays a significant role in setting interest rates in the country. Consequently, changes in the official cash rate (OCR), the interest rate banks can borrow from the RBNZ, can significantly impact swap rates and other interest rate instruments.
5. Various factors can influence swap rates, including inflation, economic growth, and geopolitical events. Swap rates are updated every working day by S&P, which uses the 5-year swap rate - you'll need to change the drop-down from "Performance" to "Yield to Maturity" to see the interest rate.
   
6. Swap rates can be used for various purposes, such as hedging against interest rate risk, managing cash flows, or speculating on interest rate movements. However, it's important to remember thatswap rates can be volatileand subject to sudden changes. Ordinary New Zealanders don't usually enter into interest swap agreements, but in recent history, there was a scandal with swap rates and farmers, best explained in this Stuff.co.nz article.
7. It's important to note that swap rates are just one of many tools available for managing interest rate risk. Other tools, such as options, futures, or interest rate swaps, may also be used depending on the specific needs of the parties involved.
8. Overall, swap rates are a complex financial instrument that plays a crucial role in managing interest rate risk in New Zealand. By understanding how swap rates work, their importance, and the risks and benefits involved, you can make informed decisions when investing or managing your finances.

Know This:Swap rates can have an impact on the wider economy in New Zealand. For example, changes in swap rates can affect the cost of borrowing for businesses and consumers, which can impact investment and spending decisions.

1. The swap market in New Zealand is relatively small compared to other financial markets, such as the foreign exchange or bond markets.However, it is still a critical component of the country's financial system and is important in managing interest rate risk.
2. The maturity of a swap agreement can have an impact on the swap rate. Generally, thelonger the maturityof the swap agreement, thehigher the swap rate will be. This is because more uncertainty and risk are associated with longer-term interest rate movements.
3. The liquidity of the swap market in New Zealand can vary depending on market conditions. In periods of volatility or uncertainty, the market's liquidity may decrease, making it more challenging to execute swap agreements at favourable rates.

Frequently Asked Questions

Who uses swap rates?

How are swap rates determined?

What is the difference between a fixed-rate and a floating-rate swap?

How long do interest rate swap agreements typically last?

Are swap rates the same as forward rates?

In the early 2000s, there was a scandal around interest rate swaps, farmers and banks. What was involved, and does it apply to a typical homeowner?

This scandal, outlined in detail in this NZ Herald article, involved the ANZ bank and farmers. The issue revolved around interest rate swaps that the farmers had entered into with the banks. The swaps were intended to protect the farmers against rising interest rates, but instead,they found themselves locked into paying high fixed rateswhile interest rates dropped. The scandal was mainly a concern for those who had entered into interest rate swap contracts, which arenot common for typical homeowners.

Typical homeowners usually have morestraightforward mortgage arrangements, such as floating or fixed-rate mortgages, and are not usually involved in interest-rate swap contracts. However, any responsible homeowner will keep an eye on interest rate trends and regularly review their mortgage options to ensure they have the most appropriate mortgage for their needs. Talking to a mortgage broker is also popular to ensure you don't overpay on mortgage renewals.

Related Guides (External):

• ​S&P Swap Rates (5 Year)
• Investopedia Swap Rates
• Wholesale Interest Rates

MoneyHub Guides:

• What is the OCR?
  
• Hedging Investments
• Home Loan Rates
• Floating vs Fixed Mortgage Calculator
• Interest Rates Explained