Financial Institutions and Interest Rate Swaps
FINANCIAL INSTUTIONS AND INTEREST RATE SWAPS
No, financial institutions should not engage in interest rate swaps for speculative purposes. In order to succeed at speculating you need the skills, experience and the ability to know what the market is going to do before it happens in the future. Given that the market is highly susceptible to just about any piece of information that is out there or any company upset, or world event there is no guarantee that what looks may happen will happen in three months, six months or one year down the road. Another way to look at speculating is it can be categorized as gambling (The Art of Speculation, 2012), you are taking a chance that you will be right at something, just like picking when the next Triple Crown winner will be.
The most common type of interest rate swaps is the fixed for floating rate swap. This is when one company essentially gives ups the guaranteed rate (fixed) on their books for a floating (variable) rate from another company. The company offering up the variable rate is looking for a more stable cash flow that the fixed rate offers and vice versa. The company receiving the floating is looking to possibly increase their cash flow if the LIBOR should rise. At the time of the swap the fixed rate payments are made known the floating initial payment is known but all remaining ones are not (Interest Rate Swap, n.d.). The risk of the interest rate dropping below the fixed rate can be quite high depending on the economy.
Even though they have expertise in forecasting, they cannot be 100% correct. In the event that they are wrong they are putting themselves at losing more money than may be necessary. These losses could wipe out any gains that were received from the other operations that the company conducts. Depending on how much risk the company is taking, if credit rating agencies deem it is excessive for any one company, their credit may be downgraded. If that should happen they will start paying higher interest rates and other fees, thereby hurting the company as a whole. Another thing to consider is what if the floating interest rate drops, the company that received it in the swap would end up losing money.
Another debate is whether or not speculation is actually needed for financial institutions regarding rate swaps. One side feels that the market status is right where it should be which makes speculating unnecessary and irrational to do. The other side sees the market as overcompensating to countless variables which could promote capital growth if done correctly (The Art of Speculation, 2012). There is no right answer to this argument. But a financial institution’s main objective is to make money for its customers and the company. Their expertise should be focused on that and not whether or not play the guessing game of speculating on what may happen down the road when there are other avenues that can get them to their goal without creating risk that is unnecessary. If they were hedging to minimize the risk or to offset the higher risk that they may be facing than that’s different. Hedging is merely taking on a derivative that is opposite of the risk they are trying to minimize. Speculating is more like taking a bet on the direction that an asset (or interest rate) will go. Speculating you are playing with fire with hopes (not security) that you will be able to put the fire out and come out ahead.