What Is a Fixed Rate Swap?
Financial swaps are arrangements in which two or more parties agree to make regular exchanges of various income streams. These swaps can take many different forms. The common form of swap involves the payment of income derived from interest paid on a loan or bond. These swaps are called "interest rate swaps." Interest rate swaps come in several varieties. A swap that involves a fixed rate of payment is known as a fixed-rate swap.
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Interest Rate Swaps
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Swaps always involve the exchange of income streams from two assets. The most common type of swap is one that involves the exchange of income derived from an asset bearing a fixed rate of interest with income derived from an asset bearing a variable rate of interest. This could be referred to colloquially as a "fixed rate" swap, as one of the assets included in the swap has a fixed rate of interest. However, it would be more commonly be called a "coupon" or "fixed for floating" swap.
Purpose
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Swaps serve two main functions for investors. They can either act as insurance or as a speculative investment. When an investor holds an asset that produces interest at a variable rate, he runs the risk that the interest rate will drop, reducing his cash flow. To insure himself against this risk, he may engineer a swap against an investor for a steady, fixed-rate income stream. By contrast, the investor with the fixed-rate income stream is swapping his cash flow not for purposes of insurance, but as a speculation that the interest rate on the variable-rate asset will remain high enough that his income will exceed the income generated by the fixed-rate asset.
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Considerations
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A fixed-rate swap never involves the exchange of cash flows deriving only from assets with a fixed rate of interest. This is because to exchange two fixed rates of interest would, if the rates were the same, usually be pointless: each party would trade the exact same amount of money. Or, if the rates were set differently, the party receiving the larger rate of interest would be assured of receiving more money than the other party.
Exception
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The only time that the exchange of two fixed-rate assets would make financial sense is if one of the revenue-generating assets was at a higher risk of defaulting than the other asset. Then, receiving payments from this asset would entail a higher risk on the part of one investor; this increased risk would entitle the investor to a larger payment than the other investor.
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