What do the Silicon Valley Bank collapse in 2023 and the UK pension fund crisis in 2022 have in common? They both shed light on the importance of interest rate risk in various sectors of the economy. From pension funds and insurers to banks, the mismatch between assets and liabilities leaves these entities vulnerable to sudden changes in interest rates. Despite the availability of interest rate derivatives for risk management, research in this field remains limited, leaving key questions unanswered. By delving into the interest rate swap market, we aim to uncover insights into how investors utilize these instruments and the impact of demand imbalances on swap prices.
Firms utilize internal rebalancing or synthetic instruments like interest rate swaps to hedge against interest rate risk. With a staggering market value of US$500 trillion in 2022, interest rate swaps have become the go-to instrument for risk management. Our research reveals persistent demand imbalances, the emergence of natural counterparties in different sectors, and the crucial role of dealers in facilitating these transactions. By employing a structural model, we analyze how demand pressures affect asset prices and explore the potential consequences of shocks to hedging demand or supply on the financial system.
Why does the interest rate swap market matter?
As interest rates rise and market disruptions unfold, the spotlight on interest rate risk intensifies. From small corporations to major financial players, the distribution of interest rate risk impacts various stakeholders. While derivatives offer hedging opportunities for businesses exposed to interest rate fluctuations, they also attract speculative market players looking to capitalize on expected rate movements.
Enter interest rate swaps (IRS) agreements – a simple yet powerful tool for hedging or speculating on interest rate risk. These agreements involve the exchange of fixed and variable payments based on prevailing interest rates. The cash flows are determined by the notional amount and maturity, spanning over 50 years in some cases. Different entities, such as pension funds and banks, have varying approaches to hedging against interest rate risk based on their business models, creating a symbiotic relationship in the swaps market.
Key facts about the interest rate swap market
- Sectoral participation and net positions: End-user segments like funds, pension funds, banks, and corporations engage in interest rate swaps based on their balance sheet requirements. This alignment suggests a natural risk-sharing relationship among sectors, optimizing hedging strategies.
-
Maturity segmentation: The market segmentation based on maturity indicates a tailored approach by different sectors. This segmentation reflects the duration gap between assets and liabilities, guiding investors towards suitable maturity ranges.
-
Firms’ responses to interest rate changes: Sectoral net positions adjust in response to interest rate fluctuations, showcasing the dynamic nature of the swaps market. Pension funds and banks act as complementary counterparties, adjusting their positions to hedge against rate movements.
-
Dealer imbalances: Despite offsetting positions between sectors, dealers manage significant imbalances. Their pivotal role as intermediaries underscores their contribution to market stability amid sector-specific demands.
Asset pricing implications
The swap spread, reflecting the difference between swap rates and bond yields, plays a crucial role in asset pricing. By exploring how demand and supply influence swap spreads, we highlight the impact of sector-specific demands on pricing dynamics. Our calibration results emphasize the role of dealers in absorbing demand imbalances and shed light on the broader implications of regulatory changes or market shocks on the swap curve.
In conclusion, our study illuminates the dynamics of interest rate risk sharing through swaps and its asset pricing implications. By analyzing sector interactions and price determinants, we offer valuable insights for policymakers and market participants. Understanding the influence of demand pressures on swap spreads is essential for navigating the intricacies of the swaps market and enhancing risk management strategies.
Leave feedback about this