Interest Rate Swaps - Financial Management

A swap is another type of financial derivative that can be used in the financing activities of a firm. A financial swap is a contractual agreement between two parties (financial institutions or businesses) to make periodic payments to each other. There are two major types of swaps: interest rate swaps and currency swaps. This section will focus on interest rate swaps. The over -the -counter swaps market, which consists of about 130 banks and securities firms, is largely unregulated. Over $5 trillion worth of interest rate swaps are outstanding worldwide.

Interest rate swaps can be used to protect financial institutions and businesses against fluctuations in interest rates. Like futures contracts, swaps can be used to hedge against interest rate risk. Even though futures contracts are more effective in hedging against shortterm risks (less than one year), swaps are more effective in hedging against longe r-term risks (up to 10 years or more).

Of the many and various types of interest rate swaps, the most basic is one in which a party is seeking to exchange floating rate interest payments for fixed rate interest payments, or vice versa. Consider the case of a finance company (e.g., Ford Credit) with floating rate debt (e.g., floating rate bonds) and fixed rate loans (e.g., automobile installment loans) that wants to protect itself against an increase in interest rates. The finance company can enter into a swap contract with another party who agrees to pay the interest costs in excess of a specified rate (e.g., 7.5 percent) for a given period of time (e.g., three years). Should interest rates increase in the future, the finance company will receive rising payments from the other party to the swap agreement to cover its losses.

The other party to the swap agreement could be a bank, which borrows at fixed interest rates (e.g., certificates of deposit) and lends money to corporations at floating rates. The bank may desire to protect itself against a decline in interest rates. Should interest rates decline in the future, the bank will continue receiving fixed interest payments from the other party to the swap agreement. This swap is illustrated in Figure. In most interest rate swaps, the floating rate used in computing the payments between the parties to the swap is tied to the London Interbank Offer Rate (LIBOR). (LIBOR is discussed in Chapter.) In this example, it is 2.5 percentage points above LIBOR. Generally, in a swap agreement, the parties exchange only the interest differential, not the principal or actual interest payments.

Many financial institutions, such as investment banks, commercial banks, and nonfinancial companies, act as intermediaries in arranging swaps. Some intermediaries act as brokers and receive commissions for finding parties with matching needs. Other intermediaries act as dealers or market makers by offering themselves as a party to the swap until such time as they can arrange a match with another party.

Interest Rate Swaps

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