As I’m sure many of you will know, it is exam period for many uni’s. I was revising with my flat mate who is on a different course and was reading through his notes just out of boredom. I’m glad I’m not on his course because it seems so complex. Feeling a bit dumb for not knowing what an interest rate swap is, I went away to look it up and here’s what I found.
An interest rate swap is an otc clearing instrument. It mainly depicts two parties agreeing to exchange specific interest rate cash flows, generally based on a specific notational amount. That notational amount usually varies from a fixed rate to a floating rate; it also varies from one floating rate to another one.
How people apply interest rate swaps
Most parties use interest rate swaps for speculation and hedging within the financial market. The most common scenario where parties utilize interest rate swaps involves, naturally, mortgages.
The scenario starts with a person who has a fixed rate mortgage. If their neighbour or another interested party has a floating rate mortgage, you might want to swap rate with your neighbour for various reasons, usually economic reasons. This especially works if your neighbour wants to have a fixed rate instead.
Instead of swapping each other mortgage, as they say, they instead make a mutual agreement to pay each other’s’ swap rate. The first party (you) would pay your neighbour’s fixed rate, while your neighbour pays the floating rate, usually indexed to what’s known as a LIBOR rate.
Both parties are still responsible for paying the original mortgage payments on their houses, but they’re also responsible for exchanging the difference between the rates (in cash). The agreement is essentially supposed to swap rates between both parties, hence the name interest rate swaps.
Why people use interest rate swaps
Interest rate swaps are more common than most people assume. They’re a necessary transaction for parties who want to swap mortgage rates with one another. Instead of having to completely restructure their mortgages, swapping their interest rate instead affords them a better mortgage rate.
Interest rate swaps are pretty common to the financial market, mainly due to the aforementioned reason. There are several reasons why people utilize interest rate swaps in the first place, besides just mortgage.
Some fixed rate income investors might expect their interest rates to fall. Instead of restructuring their investment, they choose to swap rate with another party (buying a floating-for-fixed swap rate) to pay a lower (floating rate) in exchange for their old rate.
People with hedge funds also utilize interest rate swaps to capitalize on different financial opportunities, usually arbitrage opportunities tied in the corporate credit market. Interest rate swaps and otc derivatives clearing are utilized around the world, from the standard clearing house to the biggest financial institutions.
For a better explanation of what it is, feel free to watch the video below