What Is an Interest Rate Swap Agreement?
Interest rate swaps are an important part of the fixed income market. When it comes to loans, bonds, and debt securities, the profit to the lender is in the form of interest payments made over time. Because the prevailing interest rates fluctuate constantly, however, there is some risk in being owed fixed or variable rate payments. Through swaps, lenders can effectively manage their risk. At the same time, speculators can make bets on the future movements of interest rates.
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Identification
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Interest rate swaps are over-the-counter derivatives representing an agreement between two institutions to exchange future cash flows. They are relatively common amongst large investing institutions, but do not trade on public exchanges and are virtually unknown to the average person. Their complexity, along with the large sums involved, generally makes them unsuitable for the average retail investor.
Function
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Swaps can be used to make money or to hedge and protect assets. For example, if a bank has made a 5-year loan and is receiving a fixed 3 percent return on that money, it could swap its revenue stream against someone else's 5-year money earning a variable rate. Each party to the transaction is making a play on the future of interest rates. If the rate increases, the variable rate income stream will produce more revenue than the fixed rate stream, which outperforms if rates decline. The party swapping into the fixed rate, however, could simply be creating the clarity of a fixed rate as a hedge for future investment, while the party swapping into a variable rate could be offsetting other fixed rate investments.
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Features
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The fixed rate in a swap transaction is called the swap rate. The party who has the fixed rate income and swaps into a variable is called the receiver. The counterparty is called the payer. At the maturity of the swap, the transaction is settled by exchanging the difference between the revenue streams to the appropriate party, but the principal is not exchanged. If the prevailing interest rates rise above the swap rate, the receiver is paid, but if rates fall, the payer keeps the difference.
Types
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In practice, swaps are often far more complicated. In some cases, the maturity and rates are the same, but the underlying assets are priced in different currencies. The value of the swap is then dependent on the relative fluctuations of these currencies, such as if were exchanged for 2-year euros fixed at 3 percent. Interest rate swaps can even involve simultaneous differentiations of interest rate and currency, and other variables as well.
Considerations
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Rather than speculation, a common use of swaps is to connect buyers and lenders, and to give them their desired terms. The interest rate premium required of a borrower is higher for fixed than for variable rate loans. For risky borrowers looking for long-term money, the difference in cost between a fixed rate loan and a variable rate loan can be prohibitive. A savvy lender might not be willing to own the loan at the fixed rate sought by the borrower, but can make the loan nevertheless and swap it for a variable rate income stream, allowing the lender to manage risk.
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