<p>A standard ("vanilla") interest rate swap is a contract in which one party pays a fixed rate of interest, and the other pays a floating rate (typically LiBOR, but it depends upon the market convention in the currency). (There are a lot of interest rates that deviate from this formula, but they have the same "system risk" characteristics as standard swaps.)</p>

<p>As a simplification, assume that the floating rate of interest is paid annually.</p>

<p>If you receive fixed, each year, you would net receive:</p>

<p>Net receipt = (contracted rate of interest - the "swap rate") - (latest 1-year floating rate).</p>

<p>There is no notion of "default" in the contractual payments, unlike a credit default swap.</p>

<p>From a risk perspective, this can be viewed as owning a fixed rate bond, and borrowing 100% against it at the floating rate. There is obviously leverage, which poses risks (see below).</p>

<p>The only way a default can affect you is if your counterparty fails. All that you lose is:</p>

<ul>
<li>whatever value of future payments you would have received (the Net Present Value), that is not covered by collateral.</li>
<li>You lost the interest rate risk exposure that the swap provided. If that swap was a required hedge, you need to find a new hedge.</li>
</ul>

<p>The normal procedure is that the net NPV exposure is covered by collateral; an entity would have have to be in a weak bargaining positiom (or badly informed) to enter into derivatives trading without a collateral agreement.</p>

<p>During the Financial Crisis of 2007-2008, I believe that it is safe to say that there was very little NPV losses that were incurred by inadequate collateral. That is, losses due to "defaults" was a very small number (compared to the other types of losses). The losses that were associated with interest rate swap trading was the result of needing to replace hedges that were lost when Lehman (and others) defaulted. (Not all of the problems that occurred during the Financial Crisis were documented, but I am unaware of issues in the interest rates swap market being a trigger. Once the crisis was underway, the swaps markets were dislocated, like most other ones.)</p>

<p>Otherwise, the movements in interest rates were not enough to trigger a crisis in 2007-2008. The source of the crisis was funding/credit risks.</p>

<p>You would need to go back to the 1994 bond bear market, or the LTCM Crisis of 1998 to have a historical event where interest rate swaps were a factor in the crisis.</p>

<p>In the case of 1994, there were very large movements in interest rates, coupled with risk management systems that did not really know how to measure interest rate risk. Since 1994, interest rate risk measurement is much better understood at any credibly managed investment firm or bank. (The comments about risk management are based on my knowledge of interest rate risk management that I gained from working in fixed income from 1998-2013. They are the result of my discussions with market participants who were involved with investment management during 1994. You would need to track down a paper on the evolution of interest rate risk management to get a formal reference.)</p>

<p>Whether a situation similar to 1998 or 1994 could happen again is an open question that could not expected to be answered here. Regulators are certainly aware of what happened then, so they could be expected to take actions that would prevent an exact repeat.</p>

CC BY-SA 3.0
2017-06-07T09:24:41.373Z
Thanks a lot for your clear and complete answer. Given your expertise in this area, could you maybe tell me who are the main users of interest rate swaps, financial institutions or non-financial institutions? If financial institutions are important users, which type of institutions (Banks, Insurances,…)? Many thanks for your help.
user13479
CC BY-SA 3.0
2017-06-07T11:31:30.173Z
All forms of financial institutions use swaps, but non-financial entities that borrow in the bond markets also use them. (They can convert a fixed bond to a floating interest rate.) Banks and investment dealers are the most active, for trading or continuously adjusting rate risk positions.
Brian Romanchuk
CC BY-SA 3.0
2017-06-05T15:24:06.900Z
2017-06-05T18:31:08.970Z
2017-06-05T18:31:08.970Z
Brian Romanchuk
<p>I understand the systemic risk that can be associated with the trading of credit default swaps, but is it the same with interest rate swaps? What was the "default rate" on interest rate swaps during the 2007-2008 crisis compared to CDS for instance?</p>

<interest-rate><risk><default>
Swaps and systemic risk
user13479
# Swaps and systemic risk

(Asked by: username_0 on 2017-06-05)

I understand the systemic risk that can be associated with the trading of credit default swaps, but is it the same with interest rate swaps? What was the "default rate" on interest rate swaps during the 2007-2008 crisis compared to CDS for instance?

**Tags:** interest-rate, risk, default

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## 1 answers

### Answer by username_1 on 2017-06-05. Score: 2 | Accepted answer

A standard ("vanilla") interest rate swap is a contract in which one party pays a fixed rate of interest, and the other pays a floating rate (typically LiBOR, but it depends upon the market convention in the currency). (There are a lot of interest rates that deviate from this formula, but they have the same "system risk" characteristics as standard swaps.)

As a simplification, assume that the floating rate of interest is paid annually.

If you receive fixed, each year, you would net receive:

Net receipt = (contracted rate of interest - the "swap rate") - (latest 1-year floating rate).

There is no notion of "default" in the contractual payments, unlike a credit default swap.

From a risk perspective, this can be viewed as owning a fixed rate bond, and borrowing 100% against it at the floating rate. There is obviously leverage, which poses risks (see below).

The only way a default can affect you is if your counterparty fails. All that you lose is:

* whatever value of future payments you would have received (the Net Present Value), that is not covered by collateral.
* You lost the interest rate risk exposure that the swap provided. If that swap was a required hedge, you need to find a new hedge.

The normal procedure is that the net NPV exposure is covered by collateral; an entity would have have to be in a weak bargaining positiom (or badly informed) to enter into derivatives trading without a collateral agreement.

During the Financial Crisis of 2007-2008, I believe that it is safe to say that there was very little NPV losses that were incurred by inadequate collateral. That is, losses due to "defaults" was a very small number (compared to the other types of losses). The losses that were associated with interest rate swap trading was the result of needing to replace hedges that were lost when Lehman (and others) defaulted. (Not all of the problems that occurred during the Financial Crisis were documented, but I am unaware of issues in the interest rates swap market being a trigger. Once the crisis was underway, the swaps markets were dislocated, like most other ones.)

Otherwise, the movements in interest rates were not enough to trigger a crisis in 2007-2008. The source of the crisis was funding/credit risks.

You would need to go back to the 1994 bond bear market, or the LTCM Crisis of 1998 to have a historical event where interest rate swaps were a factor in the crisis.

In the case of 1994, there were very large movements in interest rates, coupled with risk management systems that did not really know how to measure interest rate risk. Since 1994, interest rate risk measurement is much better understood at any credibly managed investment firm or bank. (The comments about risk management are based on my knowledge of interest rate risk management that I gained from working in fixed income from 1998-2013. They are the result of my discussions with market participants who were involved with investment management during 1994. You would need to track down a paper on the evolution of interest rate risk management to get a formal reference.)

Whether a situation similar to 1998 or 1994 could happen again is an open question that could not expected to be answered here. Regulators are certainly aware of what happened then, so they could be expected to take actions that would prevent an exact repeat.

> **Comments:**
> **username_0**: Thanks a lot for your clear and complete answer. Given your expertise in this area, could you maybe tell me who are the main users of interest rate swaps, financial institutions or non-financial institutions? If financial institutions are important users, which type of institutions (Banks, Insurances,…)? Many thanks for your help.  
> **username_1**: All forms of financial institutions use swaps, but non-financial entities that borrow in the bond markets also use them. (They can convert a fixed bond to a floating interest rate.) Banks and investment dealers are the most active, for trading or continuously adjusting rate risk positions.  

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