Swaps
To municipal issuers, the most important type of swap is the interest rate swap. At its most basic level, an interest rate swap is an agreement or contract between two parties to exchange regular interest payments for a specified period of time. This is called a plain vanilla interest rate swap. In the municipal world the issuer usually has a bond with either a fixed rate of interest that it swaps with a financial institution for a variable rate, or it has a bond with a variable rate that it swaps for a fixed rate. The financial institution, which is usually a swap dealer, is considered the “counterparty” on the transaction, though sometimes both parties are referred to as counterparties.
Here’s how it works. Goodville has a $50 million bond with a semiannual floating rate interest payment of LIBOR + 2%. London Interbank Offered Rate (LIBOR) is the overnight lending rate among banks in the London interbank market. It is the global benchmark for short-term interest rates, and it is commonly used to structure interest rate swaps.
Goodville is nervous about its obligation to pay interest at a variable rate because of the volatility in the interest rate market. The city council would like to know exactly how much it has to pay in interest every year for planning purposes. It is also worried that interest rates will rise and it will have to pay more than it expects. Great Bank, a financial institution and also a swap dealer, expects interest rates to drop in the future and is willing to take on a variable rate obligation. Great Bank offers to exchange a fixed rate for Goodville’s variable rate. Great Bank is using the swap to speculate about the movement of interest rates. The value of a swap agreement given current interest rates is known as the mark-to-market value of the swap. As interest rates change, both parties will continue to calculate the mark-to-market value to help predict their future payments.
To meet its budget goals, Goo