Issuers unfamiliar with swaps often wonder why a seasoned investment bank is willing to act as a swap counterparty, taking the opposite side of a transaction.
The question boils down to this: "Why would I want to do the opposite of what a fancy Wall Street firm does?"
As it turns out, the firm usually doesn't differ with the issuer about where the market may be heading.
Instead, the deal fits into a whole network of swaps or other future transactions that are supposed to balance out one another. In short, the firm is going to be hedging its position.
Most firms that act as swap dealers run a matched book. All of the firm's swaps seen together -- a portfolio of swaps -- constitute the book. Since every swap has an offsetting hedge, the book is said to be matched.
On some of the swaps, the firm is obligated to pay a fixed rate of interest while receiving a floating rate. On other swaps, the firm does the reverse.
If interest rates rise, the firm gains from the swaps in which it receives a floating rate but loses from swaps in which it pays a floating rate. If the book is fully matched, the rise in rates will have little or no effect on the firm's swap profits.
Many firms also try to hedge their swap book on the basis of maturity and credit quality. A two-year swap with a single-A-rated issuer paying a fixed rate is not a good hedge for a 10-year swap with a triple-A-rated issuer receiving a fixed rate. Managing the swap book requires constant monitoring and hedging of all of the risks.
Many firms also use Eurodollar futures contracts to hedge their swaps. The futures contracts, available out to 10 years, allow the holder to lock in a future short-term interest rate.
But if everything is fully hedged, how does the firm make a profit? The profit comes not from taking a view on interest rates, but from the mundane bid-ask spread.
A firm charges the spread by paying a slightly lower fixed rate than it charges for taking the reverse position in an identical swap.
For example, a firm might offer to pay an issuer 5% on $100 million over five years. In return, the issuer agrees to pay a floating rate based on the Public Securities Association's municipal swap index on the $100 million.
What if the issuer wanted to pay the fixed rate and receive the floating rate? Then the firm would demand a slightly higher fixed rate, say 5.12%, than it offered to pay on the same floating rate.
The bid-ask spread varies depending on several factors. Longer maturity swaps tend to have wider spreads because of the increased credit risk and the lack of competition. Firms may also adjust their spreads depending on supply and demand or specific needs in their swap book. offset one swap with a perfectly matching reverse swap, however. For example, in the municipal market, most issuers want to pay a fixed rate and receive a floating rate.
What can the firm do?
It might turn to the taxable swap market. But that adds an additional risk. Rates in the tax-exempt market do not always move in tandem with rates in the taxable market.
So the firm might use futures contracts to hedge against a change in the relationship between taxable and tax-exempt rates.