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Disadvantages of Interest-Rate Swaps

Although interest-rate swaps have important advantages that make them very popular with financial institutions, they also have disadvantages that limit their usefulness. Swap markets, like forward markets, can suffer from a lack of liquidity. Let's return to looking at the swap between the Midwest Savings Bank and the Friendly Finance Company. As with a forward contract, it might be difficult for the Midwest Savings Bank to link up with the Friendly Finance Company to arrange the swap. In addition, even if the Midwest Savings Bank could find a counterparty like the Friendly Finance Company, it might not be able to negotiate a good deal because it cannot find any other institution with which to negotiate.

Swap contracts also are subject to the same default risk that we encountered for forward contracts. If interest rates rise, the Friendly Finance Company would love to get out of the swap contract, because the fixed-rate interest payments it receives are less than it could get in the open market. It might then default on the contract, exposing Midwest Savings to a loss. Alternatively, the Friendly Finance Company could go bust, meaning that the terms of the swap contract would not be fulfilled.

Financial Intermediaries in Interest-Rate Swaps

As we have just seen, financial institutions do have to be aware of the possibility of losses from a default on swaps. As with a forward contract, each party to a swap must have a lot of information about the other party to make sure that the contract is likely to be fulfilled. The need for information about counterparties and the liquidity problems in swap markets could limit the usefulness of these markets. However, as we saw in Chapter 8, when informational and liquidity problems crop up in a market, financial intermediaries come to the rescue. That is exactly what happens in swap markets. Intermediaries such as investment banks and especially large commercial banks have the ability to acquire information cheaply about the creditworthiness and reliability of parties to swap contracts and are also able to match up parties to a swap. Hence large commercial banks and investment banks have set up swap markets in which they act as intermediaries.

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