Interest rate swaps

In a previous post I stated that interest rate swaps are easy to understand. They are, but I guess they are not really a widely understood concept. So let me take a shot here at explaining an interest rate swap.

First you need to understand interest rates. If you borrow money you pay interest on it. If you borrow money today and return it tomorrow, you will pay a lower interest rate than if you borrow money today and return it after a year. There are many scientific reasons why this is the case, but mostly it is because we do not trust you. You cannot get very far in a day, but you could probably be in Mexico by year-end.

So anyway, we now have a market where you can borrow at a specific rate for each length(also called tenor) of borrowing. So you have an overnight rate and a one year rate and a two year rate and so on. This is called the yield curve. So far I think we are all good.

Now we come to the complex math that only rocket scientists can understand. We will need examples to understand this. If you have a 6 month rate of 5% and a one year rate of 10%, this implies a 6month rate, 6 month forward, of around 15%. How did this happen ? Well you can break the one year period into two 6month periods. The first 6months have an interest rate of 5% and the second six months have a rate of 15%, so that the average rate over the one year is 10%. My math is not accurate as I did some rough examples to illustrate the concept. However, you get the gist of it. This 15% rate is called the 6 month "forward rate". If I have a 6month rate quoted in the market, and I have a one year rate quoted in the market, then it implies that there is a 6month forward rate which is some kind of average between the two. It will be higher than the other two rates but that is getting too technical.

So anyway, all across the yield curve, all the way to thirty years, there exists these forward rates. What an interest rate swap does is that it agrees to exhange these forward rates for a Fixed rate. So if you have a floating rate mortgage that resets every 6months, I can swap your floating rate for a fixed rate. You will obviously pay me handsomely for this piece of Financial wizardry where you pay me a fixed rate to take away the risk of your ever changing floating rate. However, this fixed rate that I offer you on the swap will still be lower than if you were to go out and try to get a fixed rate for thirty years.

So there you have it - Interest rate swaps for dummies. Leave me your questions. Why is it necessary for you to understand this ? Ever since the Federal government decided to let interest rates float in the name of a free market, you pretty much have no choice but to understand this complication. It is like having to understand your taxes, a mutual fund, a 401k fund. The free market makes things complicated and dangerous for an innocent, naive or ignorant public.

Btw..look at the financials of all the major Wall street firms and ask them how much of their earnings come from plain vanilla interest rate swaps. Then listen to their arguments about how they are absolutely forced to pay top dollar to keep their "talent" from gong to the competition. They would have you believe all the dollars are going towards keeping extreme brainâcs continuously occupied, in this very complex business. Believe you me, the only talent involved here is in keeping the world spinning...around Wall street. There are mostly shamans and snake oil salesmen, that get to keep the top dollar, for producing absolutely nothing. Many of them probably do not even know the math behind the above simple product. All they know is that dim lighting and cheap merchandise are all that is required to turn a profit. Also, a monopoly in the business, helps keep profits high and competition out of sight.