Thursday, March 10, 2016

$320 Trillion

Whaley, Markets, Valuation, and Risk Management, 2006

Interest rate derivative contracts seem less in the spotlight than are derivatives on stocks and stock indexes. [..]  It [also] should not be surprising [..] that interest rate risk management is a primary concern for corporations, agencies, municipalities, and governments. Indeed, more than two-thirds of all [over-the-counter] derivatives traded worldwide are written on interest rate instruments.

The first interest rate derivative contract on an exchange appeared 30 years ago, when the CBT introduced futures contracts on GNMA pass-through certificates. Futures contracts on U.S. Treasury bonds, notes, and bills quickly followed. Options on interest rate instruments were launched in late 1982. Even though many of these markets have become incredibly active by exchange standards, the greatest success story is the OTC interest rate swap market. The first interest rate swap was consummated in 1981. Today, about 20 years later, interest rate swaps account for more than half the notional amount of all derivatives outstanding worldwide.

Report, BIS

The interest rate segment accounts for the majority of OTC derivatives activity. At end-June 2015, the notional amount of outstanding interest rate derivatives contracts totalled $435 trillion, which represented 79% of the global OTC derivatives market [..] At $320 trillion, swaps account for by far the largest share of this market segment.

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Jesus flippin Christ. These are staggering amounts.. Interest rate swaps allow borrowers to swap their multiple-period payments with eachother, usually one payment is based on fixed interest rate the other on floating rate, a formula is worked out between both payers so they pay each other according to that formula with the result that they end up with each others outward cash flow. This payment is then handed over to their respective lenders. A more technical explanation is here, by none other than Salman Khan himself.

People abhor unnecessary certainty, especially in businesss, and uncertainty around interest rates seem to be such a pain-in-the-ass known unknowns that everyone seems to want to hedge around. The staggering size of the swap market proves this.

The BIS report also talks about regulators pushing for a switch from over-the-counter towards exchanges for this market. This is a good thing - most interest rate swaps are pretty standard anyway, there should be no reason this stuff to continue to flow through Too Big To Fail institutions (another reason for the sausage makers' bail-out, they were probably part of a big chunk of that mammoth  swap market right there,  they became not only they also became Too Connected To Fail. If such amounts are flowing through a company, everyone depends on them, they can't simply be removed without undue pain).