Interest rates swaps are a way for financial bodies to exchange risk on the movement of interest rates. They were originally designed as a way for firms to avoid exchange rate controls because interest rate swaps can be done in different currencies.
Interest rate swaps are one of the most common type of derivatives and are highly liquid (meaning easy to buy and sell).
The most common type of interest rate swap is a combination of fixed and variable rate payments.
In this example.
Firm A wishes to swap variable interest payments for fixed interest payments. Bank B is happy to pay a variable rate in return for a fixed rate
- Firm A pays a fixed rate to Bank B. (e.g. a rate of 5%)
- Bank B pays a variable rate to Bank A. (e.g. Libor rate + 0.5%)
- A notional amount is decided on e.g. £1m so this will determine the amount of interest paid.
This means that Bank B gets a fixed interest payment of £50,000
Bank A is receiving a variable interest payment which depends on the libor rate
Firm A is paying a constant interest payment.
Firm B is experiencing the risk associated in changing interest rates. The amount it has to pay depends on interest rate movements.
If interest rates increase Bank B pays more to firm A, if interest rates goes down it pays less to firm A
Suppose a firm took out a loan and had to pay variable interest payments on this loan. The firm would be vulnerable if interest rates rose rapidly. This would increase its costs and could make the firm go under.
Therefore, to hedge against a rise in interest rates, the firm, may seek to enter into an interest rate swap. It would choose a situation where it would receive a variable rate and paid a fixed rate.
Therefore, if interest rates rose it would have higher costs from its loan. But, this would be compensated by receiving a higher variable rate on its interest rate swap. Therefore, if interest rates rose, it would not be as damaging for the firms costs.
In this way an interest rate swap provides a mechanism for firms (or other institution) to hedge against rising interest rates. Of course, it means they don’t benefit from falling interest rates, but, they have greater certainty over their costs and payments.