An Introduction to Rate Swaps

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In the investment world, derivatives can be divided into two distinct and separate families:

    Contingent claims, or options
    Forward claims, or rate swaps, futures, and forward contracts

Rate swaps are agreements between two separate parties. With these agreements, the parties can exchange certain cash flows for a specific period of time. Typically, the cash flows are determined by random variables like interest rates, equity prices, commodity prices, or foreign exchange rates.

Unlike options and futures, these swaps are not instruments that are exchange traded. Instead, they are custom contracts organized between private parties over-the-counter. In general, the majority of swaps occurs on the market between corporations, firms, and financial institutions.

There are two basic types of swaps. Today we are going to discuss the most common of the two: plain vanilla interest rate swaps.

Plain Vanilla Interest Rate Swap

The simplest type of swap available on the market today is known as a "plain vanilla" swap. With this swap, one party agrees to pay another party a fixed and predetermined interest rate on a security for a specific amount of time. At the same time, the second party agrees to pay the first party a certain amount of money for a floating rate of interest for the same security and the same amount of time. The two separate cash flows are paid with the same type of currency.

The dates that each payment is made are known as settlement dates and the time between each of these dates are known as settlement periods. The dates for each swap can vary, requiring monthly, quarterly, or even annual settlement dates. All of this information is typically tracked using rate swap spreadsheets.

Why Use a Swap?

There are two basic reasons an individual or corporation might wish to use a swap:

    Commercial needs- When a business operates, there can be times when certain kinds of interest rates or exposures to currency occur. Rate swaps can eliminate these exposures. For instance, if a bank pays a floating rate on their deposits, or liabilities, and receives a fixed yield rates on their loans, or assets, they may have difficulties because of the mismatch that occurs between their liabilities and assets. By using a rate swap to obtain a fixed interest rate for their liabilities and a floating rate for their loans, they may end up paying less and receiving more from their interest.
    Comparative advantage- With some companies, certain types of financing produce a comparative advantage. However, the kind of comparative advantage received may not be the one they desire. If this is the case, they can use a rate swap to convert the advantage to a type of financing they want. Most often one that is more profitable.

Rate swaps can be very advantageous for your business, if you take the time to understand what they are and how they can be used. Use this information when performing an interest rate swap and always remember to be cautious with these over-the-counter swaps because there is always a risk of the other party defaulting.

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