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Interest rate swaps (Users (Financial institutions (such as investment and…
Interest rate swaps
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Risks
Interest rate changes may affect the floating interest rate payer as the rate is linked to an index, if the index increases considerably this could cause anticipated profits to vanish or losses to be incurred
If interest rates rise, the fixed rate payer benefits while the payer of floating rate loses out
If interest rates fall, the payer of fixed interest rate loses out while the payer of floating rate will benefit
There is a chance that one of the coutnerparties may default on its obligations to make interest payments. The risk should be lower the higher the credit rating of the counterparty and in general the counterparty making the fixed rate payments is considered less creditworthy than the counterparty with the floating rate obligation
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A contractual agreement between two counterparties where one agues to swap with the other a stream of fixed-interest payments (cash flows) in return for a stream of floating-rate interest payments. Both interest streams are based on the same notional (hypothetical) amount over a specific period
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Classed as derivatives as their own existence is based on an underlying asset, be this hypothetical. Instead the interest rates are based on the notional amount
Exchanges of interest payments take place during an agreed period. These interest rates are usually established at the start of the contract period and settled at the end
As there no exchange of a principal sum , they are deemed to be off balance sheet transactions
The floating rate will be based on an index such as LIBOR whereas the fixed interest rate may be based on a different index
Where both parties are non financial companies there will also be a financial institution involved which will serve as an intermediary charging for its services in the process
The participants involved in an interest rate swap are always referred to from the perspective of the payment of the fixed stream of interest payments
The counterparty making the fixed interest payments while receiving the floating rate stream of interest rate payments after the start of the swap is referred to as the payer,whereas the counterparty receiving the fixed stream of interest payments while making floating interest rate payments, after the inception of the swap, is referred to as the ‘receiver’
Hedgers will use interest rate swaps in order to manage their interest rate exposure and their fixed and floating assets and obligations
Speculators will speculate on future interest rate movements. One who expected interest rates to fall would obtain a floating rate obligation and swap this for a fixed rate. As the floating rate obligation falls, the speculator will pay a lower floating rate in exchange for the same fixed rate
Because of differing credit ratings between counterparties, there are opportunities for arbitrage by those who are therefore known as arbitrageurs
Companies use interest rate swaps to manage exposure to changes in interest rates. Financial institutions make a considerable amount of their revenue from being involved in the swaps market