Interest rate swap
Contract exchanging interest flows between a fixed and a floating leg on a notional that never changes hands. It is the main instrument for hedging an insurer's duration gap.
An interest rate swap exchanges interest flows computed on a notional that never changes hands: one party pays a fixed rate and receives a floating rate, the other does the reverse. Its appeal to an insurer is that it adds or removes rate sensitivity without buying or selling bonds, hence without disturbing the asset allocation or realizing gains. A life insurer with a negative duration gap protects itself against falling rates by receiving fixed on a long swap: the swap's value rises when rates fall, offsetting the heavier liability. Three drawbacks come with the instrument, and all of them have cost someone dearly. A swap consumes collateral, and margin calls on an adverse move settle in cash, which creates a liquidity need at the worst moment. It carries counterparty risk, mitigated but not removed by central clearing. And it exposes the holder to basis risk, the swap curve and the liability discounting curve not moving exactly together.
The liability-driven investment crisis in the United Kingdom in September and October 2022 illustrates the first of these three risks at market scale. The abrupt rise in long rates turned fixed-receiving positions heavily loss-making. Pension funds had to meet the resulting margin calls by selling the very bonds backing their hedge. That amplified the move until the Bank of England intervened.
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