An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party’s stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. Unlike corporate bonds, interest rate swaps do not involve risk on the principal amount[1]. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments.
Uses
Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.
An interest rate swap usually involves just two parties, but occasionally involves more. Often, an interest rate swap involves exchanging a fixed amount per payment period for a payment that is not fixed (the floating side of the swap would usually be linked to another interest rate, often the LIBOR). In an interest rate swap, the principal amount is never exchanged, it is just a notional principal amount.
Users and Uses of Interest Rate Swaps
Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons:
1. To obtain lower cost funding
2. To hedge interest rate exposure
3. To obtain higher yielding investment assets
4. To create types of investment asset not otherwise obtainable
5. To implement overall asset or liability management strategies
6. To take speculative positions in relation to future movements in interest rates.
The advantages of interest rate swaps include the following:
1. A floating-to-fixed swap increases the certainty of an issuer’s future obligations.
2. Swapping from fixed-to-floating rate may save the issuer money if interest rates decline.
3. Swapping allows issuers to revise their debt profile to take advantage of current or expected future market conditions.
4. Interest rate swaps are a financial tool that potentially can help issuers lower the amount of debt service.
Typical transactions would certainly include the following, although the range of possible permutations is almost endless.