Interest rate swaps

The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative
market. The notional amount outstanding as of December 2006 in OTC
interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from
December 2005.

That’s from Wikipedia.
You’ll see other estimates as well, although they fall within a few
hundred trillion of this number.  If it makes you feel any better, swap
numbers usually measure the total liabilities in the market, not the
size of the swapped payments.  So you could argue that "the real
number" is maybe 1/20th of this or so, with error margins of only
trillions remaining.

Oddly economists don’t have a clear explanation for swaps.  In a
classic "plain vanilla" swap you trade a fixed rate interest payment
for a floating rate payment and of course the swaps occur across
currencies as well.  So here’s a typical story: Bank A takes out a
floating rate loan in terms of Swiss francs (from C) and Bank B takes
out a fixed rate loan in terms of Japanese yen (from D).  Bank A and
Bank B then decide they each would rather have each others’ liabilities
and so they swap interest payments.  That’s called the comparative
advantage theory.

But why didn’t Bank A borrow in yen from D to begin with?  And why
didn’t Bank B borrow in Swiss Francs from C to begin with?  OK, they
"changed their minds."  Is that how you get to all those trillions?

Or maybe lender D didn’t trust Bank borrower A in the first place
and would have charged an excess risk premium.  But then why does Bank
B trust Bank A so much? 

Is there a regulatory arbitrage argument here?  Under Basel I, a
bank might prefer to get a non-risky loan off its books to avoid the
associated capital requirements.  Clearly that drives some of the
market but regulators have been working on
remedying that problem and no one was expecting the swaps market to
disappear as a result.  Furthermore the interest rate swaps predated
the Basel agreements.  Another regulatory arbitrage argument cites the
difference between the U.S. and Eurodollar markets.

Here is one survey of explanations for interest rate swaps.  The explanations mostly seem lame and question-begging to me.  Here is another survey of potential explanations of interest rate swaps.  Good luck and I hope you have JSTOR access.  Here is a useful non-gated summary.

It is a shame that economists have devoted so little attention to
understanding interest rate swaps.  It’s hard to get the data for doing
first-rate quantitative finance work, so the topic tends to be
ignored.  Right now it would be nice to know how much of this market is
real gains from trade and how much is a zero- or even negative-sum game
of some kind.  I believe that practitioners have a better sense of this
than do the academics, myself included.

The bright side is that — as far as we’ve been told — this
massive, unregulated interest rate swaps market has not been a major
driver for troublesome counterparty risk.  The credit default swaps
have been the culprit there, in part because those latter markets are
based on large, discrete default events, which kick in quickly and
require very large surprise payments.

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