Interest Rate Swaps - The Definitive New Zealand Guide
Our guide explains interest rate swaps and their importance for managing interest rate risk for banks and companies in New Zealand. We cover how swaps work, the risks involved, and their impact on everyday residential borrowers.
Updated 20 February 2023
Summary:
Our guide covers:
- Interest swap rates are agreements between two parties to exchange cash flows based on a predetermined fixed or floating interest rate.
- Swap rates allow banks, companies, and investors to manage interest rate risk by locking in a fixed interest rate for a specific period.
- Increasing swap rates can lead to higher floating interest rates for borrowers with floating-rate mortgages while decreasing swap rates can lead to lower floating interest rates.
- Interest rate swaps involve two primary risks; interest rate risk and credit risk, but we believe credit risk is low in New Zealand given it is the banks that predominantly enter into swap contracts.
- The New Zealand 90-day bank bill rate is the benchmark rate for floating interest rate payments in New Zealand swap agreements.
- Swap rates can be used for various purposes, such as hedging against interest rate risk, managing cash flows, or speculating on interest rate movements. However, they're just one of many tools available for managing interest rate risk.
Our guide covers:
MoneyHub Founder Christopher Walsh shares his views on the best sources of interest rate swap data:"S&P and interest.co.nz are two reputable sources of swap rate data in New Zealand that I'm proud to profile on MoneyHub".
"S&P is a global financial information and analytics company that provides ratings, research, and data on various financial markets and instruments, including swap rates. They are known for their rigorous methodology and reliable data, making them a trusted source for investors, everyday New Zealanders and financial institutions". "Interest.co.nz is a New Zealand-based news and information website that provides comprehensive coverage of various financial markets, including the interest rate market. They provide regular updates on swap rates and other financial indicators, as well as in-depth analysis and commentary from industry experts. Their focus on the New Zealand market makes them a valuable resource for those looking for local insights and information. Swap rate data is supplied by the NZFMA, the New Zealand Financial Markets Association (not to be confused with the FMA)". |
Christopher Walsh
MoneyHub Founder |
How Interest Rate Swaps Work
A swap rate is an agreement between two parties to exchange cash flows based on a predetermined fixed or floating interest rate. The parties involved in a swap agreement are called the "fixed-rate payer" and the "floating-rate payer." The fixed-rate payer agrees to pay a fixed interest rate to the floating-rate payer, who agrees to pay a floating interest rate based on a benchmark rate such as the New Zealand 90-day bank bill rate.
The swap rate is the fixed interest rate that the fixed-rate payer agrees to pay the floating-rate payer. The swap rate is calculated based on the difference between the fixed interest rate and the floating interest rate and the period over which the swap agreement will run.
For example, if Westpac has issued floating-rate loans to borrowers and then decides to convert the floating interest rate on the loan to a fixed interest rate, Westpac can enter into a swap agreement with another party (for example, ASB) to exchange the floating interest rate payments for fixed interest rate payments. The swap rate will be determined based on the difference between the floating interest rate and the fixed interest rate and the period over which the swap agreement will run.
Know This: Interest rate swaps first helped banks manage their floating-rate debt liabilities by allowing them to agree with other banks or counterparties to pay fixed rates and receive floating-rate payments. This meant that banks could pay a fixed interest rate but receive payments matching their floating-rate debt. But, of course, they could also do the opposite – pay floating rates and receive a fixed interest rate.
Swaps have now evolved to reflect the market's expectations for interest rates in the future; hence higher movements in swap rates reflect the possibility of increasing interest rates and vice versa. For this reason, they are closely watched by housing market commentators as a predictor of mortgage lending rates.
The swap rate is the fixed interest rate that the fixed-rate payer agrees to pay the floating-rate payer. The swap rate is calculated based on the difference between the fixed interest rate and the floating interest rate and the period over which the swap agreement will run.
For example, if Westpac has issued floating-rate loans to borrowers and then decides to convert the floating interest rate on the loan to a fixed interest rate, Westpac can enter into a swap agreement with another party (for example, ASB) to exchange the floating interest rate payments for fixed interest rate payments. The swap rate will be determined based on the difference between the floating interest rate and the fixed interest rate and the period over which the swap agreement will run.
Know This: Interest rate swaps first helped banks manage their floating-rate debt liabilities by allowing them to agree with other banks or counterparties to pay fixed rates and receive floating-rate payments. This meant that banks could pay a fixed interest rate but receive payments matching their floating-rate debt. But, of course, they could also do the opposite – pay floating rates and receive a fixed interest rate.
Swaps have now evolved to reflect the market's expectations for interest rates in the future; hence higher movements in swap rates reflect the possibility of increasing interest rates and vice versa. For this reason, they are closely watched by housing market commentators as a predictor of mortgage lending rates.
Why are Swap Rates Important?
- Swap rates are important in financial markets because they enable banks, companies, and investors to manage interest rate risk. Interest rate risk is the risk that the value of a financial instrument will decline due to changes in interest rates. For example, if interest rates rise, the value of a fixed-rate bond will decline because the interest payments on the bond are fixed and do not increase with rising interest rates. Our guide to bonds and investing in New Zealand bonds explain more.
- Using swap rates, banks, companies, and investors can hedge against interest rate risk by locking in a fixed interest rate for a specific period. This can help to stabilize their cash flows and protect them against interest rate volatility. Swap rates also play a critical role in pricing various financial instruments and are most popular in the mortgage market.
What do increasing and decreasing swap rates indicate for New Zealanders with mortgages?
If swap rates increase, banks' borrowing costs may also increase, resulting in higher floating interest rates for borrowers with floating-rate mortgages. On the other hand, if swap rates decrease, the banks' borrowing costs may also decrease, leading to lower floating interest rates for borrowers with floating-rate mortgages. For those with fixed-rate mortgages, changes in swap rates may not immediately impact their interest rates since they are fixed for a specified period.
What's the difference between the OCR and swap rates?
The overnight domestic cash (interest) rate, or OCR, is a key interest rate set by the Reserve Bank of New Zealand and directly affects short-term interest rates such as floating home loan rates. As the bank for the banks, the Reserve Bank sets the OCR, the interest rate paid to banks for their deposits with the Reserve Bank, essentially the bank's interest income.
On the other hand, swap rates are the rates at which parties are willing to swap floating income for fixed income. These rates are particularly influential for longer-term home loan rates, such as those fixed for one or more years.
To ensure they can match the maturity of their assets (loans out) with their liabilities (deposits in), banks use interest rate swap contracts to hedge future interest rate risk. For this reason, home loan rates are determined by swap rates, which are the prices banks pay to lend for longer maturities.
In summary, while the OCR significantly impacts short-term interest rates, swap rates play a crucial role in determining longer-term home loan rates, as they allow banks to manage their interest rate risk and ensure they can match the maturity of their assets with their liabilities.
On the other hand, swap rates are the rates at which parties are willing to swap floating income for fixed income. These rates are particularly influential for longer-term home loan rates, such as those fixed for one or more years.
To ensure they can match the maturity of their assets (loans out) with their liabilities (deposits in), banks use interest rate swap contracts to hedge future interest rate risk. For this reason, home loan rates are determined by swap rates, which are the prices banks pay to lend for longer maturities.
In summary, while the OCR significantly impacts short-term interest rates, swap rates play a crucial role in determining longer-term home loan rates, as they allow banks to manage their interest rate risk and ensure they can match the maturity of their assets with their liabilities.
Understanding the Risks of Interest Rate Swaps
There are two primary risks – interest rate risk and credit risk. Because the New Zealand interest rate market is predominantly interbank, the credit risk is arguably low.
- Understanding the interest rate risk: Interest rates move around, and it's not uncommon for banks to get their predictions wrong. This means the bank receiving fixed-rate interest will profit if interest rates fall and lose if interest rates rise. Conversely, the bank paying fixed-rate interest to the other bank will profit if interest rates rise and lose if interest rates fall.
- Understanding credit risk: This is the chance that either contracting party to an interest rate swap defaults on its responsibility to make payments. The risk is low given the capital reserves of New Zealand banks and the fact that the overall risk of interest rate swaps causing material losses to a bank is low.
Must-Know Facts About Swap Rates
Our list of facts is published to help explain interest rate swaps further:
Know This: Swap rates can have an impact on the wider economy in New Zealand. For example, changes in swap rates can affect the cost of borrowing for businesses and consumers, which can impact investment and spending decisions.
- The market forces of supply and demand determine swap rates. In addition, the swap rate reflects the expectations of market participants regarding future interest rate movements.
- Swap rates are quoted in basis points. A basis point is equal to 0.01%, so a swap rate of 50 basis points is equal to 0.50%. Our basis points calculator explains more details.
- The New Zealand 90-day bank bill rate is the benchmark rate for floating interest rate payments in New Zealand swap agreements.
- The Reserve Bank of New Zealand (RBNZ) plays a significant role in setting interest rates in the country. Consequently, changes in the official cash rate (OCR), the interest rate banks can borrow from the RBNZ, can significantly impact swap rates and other interest rate instruments.
- Various factors can influence swap rates, including inflation, economic growth, and geopolitical events. Swap rates are updated every working day by S&P, which uses the 5-year swap rate - you'll need to change the drop-down from "Performance" to "Yield to Maturity" to see the interest rate.
- Swap rates can be used for various purposes, such as hedging against interest rate risk, managing cash flows, or speculating on interest rate movements. However, it's important to remember that swap rates can be volatile and subject to sudden changes. Ordinary New Zealanders don't usually enter into interest swap agreements, but in recent history, there was a scandal with swap rates and farmers, best explained in this Stuff.co.nz article.
- It's important to note that swap rates are just one of many tools available for managing interest rate risk. Other tools, such as options, futures, or interest rate swaps, may also be used depending on the specific needs of the parties involved.
- Overall, swap rates are a complex financial instrument that plays a crucial role in managing interest rate risk in New Zealand. By understanding how swap rates work, their importance, and the risks and benefits involved, you can make informed decisions when investing or managing your finances.
Know This: Swap rates can have an impact on the wider economy in New Zealand. For example, changes in swap rates can affect the cost of borrowing for businesses and consumers, which can impact investment and spending decisions.
- The swap market in New Zealand is relatively small compared to other financial markets, such as the foreign exchange or bond markets.However, it is still a critical component of the country's financial system and is important in managing interest rate risk.
- The maturity of a swap agreement can have an impact on the swap rate. Generally, the longer the maturity of the swap agreement, the higher the swap rate will be. This is because more uncertainty and risk are associated with longer-term interest rate movements.
- The liquidity of the swap market in New Zealand can vary depending on market conditions. In periods of volatility or uncertainty, the market's liquidity may decrease, making it more challenging to execute swap agreements at favourable rates.
Frequently Asked Questions
Swaps are not contracts you enter into unless you're a bank or specifically need to manage interest rate risks. Our list of common queries below is designed to help make sense of the mechanics.
Who uses swap rates?
Banks, companies and investors use swap rates to manage interest rate risk. Swap contracts are not consumer-focused, meaning it's unlikely retail investors will enter into agreements with other parties. However, we have published this guide to help people understand them and how they influence the prediction of mortgage rates.
How are swap rates determined?
Swap rates are determined by the market forces of supply and demand, and they reflect the expectations of market participants regarding future interest rate movements.
What is the difference between a fixed-rate and a floating-rate swap?
In a fixed-rate swap, one party pays a fixed interest rate to the other, which pays a floating interest rate based on a benchmark rate. The parties exchange floating interest rate payments based on different benchmark rates in a floating-rate swap.
How long do interest rate swap agreements typically last?
Agreements can last from a few months to several years, depending on the needs of the parties involved. Generally, the longer the term, the higher the swap rate.
Are swap rates the same as forward rates?
No - a forward rate is a rate at which a currency or asset can be exchanged in the future, whereas a swap rate is an agreement to exchange cash flows based on predetermined interest rates.
In the early 2000s, there was a scandal around interest rate swaps, farmers and banks. What was involved, and does it apply to a typical homeowner?
This scandal, outlined in detail in this NZ Herald article, involved the ANZ bank and farmers. The issue revolved around interest rate swaps that the farmers had entered into with the banks. The swaps were intended to protect the farmers against rising interest rates, but instead, they found themselves locked into paying high fixed rates while interest rates dropped. The scandal was mainly a concern for those who had entered into interest rate swap contracts, which are not common for typical homeowners.
Typical homeowners usually have more straightforward mortgage arrangements, such as floating or fixed-rate mortgages, and are not usually involved in interest-rate swap contracts. However, any responsible homeowner will keep an eye on interest rate trends and regularly review their mortgage options to ensure they have the most appropriate mortgage for their needs. Talking to a mortgage broker is also popular to ensure you don't overpay on mortgage renewals.
Typical homeowners usually have more straightforward mortgage arrangements, such as floating or fixed-rate mortgages, and are not usually involved in interest-rate swap contracts. However, any responsible homeowner will keep an eye on interest rate trends and regularly review their mortgage options to ensure they have the most appropriate mortgage for their needs. Talking to a mortgage broker is also popular to ensure you don't overpay on mortgage renewals.
MoneyHub Founder Christopher Walsh shares his views on the best sources of interest rate swap data:"S&P and interest.co.nz are two reputable sources of swap rate data in New Zealand that I'm proud to profile on MoneyHub".
"S&P is a global financial information and analytics company that provides ratings, research, and data on various financial markets and instruments, including swap rates. They are known for their rigorous methodology and reliable data, making them a trusted source for investors, everyday New Zealanders and financial institutions". "Interest.co.nz is a New Zealand-based news and information website that provides comprehensive coverage of various financial markets, including the interest rate market. They provide regular updates on swap rates and other financial indicators, as well as in-depth analysis and commentary from industry experts. Their focus on the New Zealand market makes them a valuable resource for those looking for local insights and information. Swap rate data is supplied by the NZFMA, the New Zealand Financial Markets Association (not to be confused with the FMA)". |
Christopher Walsh
MoneyHub Founder |
