what is an interest swap?

Question

IRS

Answer 1

An interest rate swap is a contract between two parties where one (the fixed rate payer) agrees to make fixed rate payments to the other and the other (the floating rate payer) agrees to make floating rate payments to the first.

Here is an example. We agree on a "notional" amount -- say $10,000,000. Perhaps I agree to make payments of 6% per year to you paid quarterly (that would be 1.5% of $10,000,000 every three months). In return, you agree to pay me the LIBOR rate every three months (LIBOR stands for London Inter-Bank Offer Rate and is a rate that changes daily & represents the rate at which one high quality bank in London will lend to another).

Since we are both making payments, we net them -- and only one payment is made. If interest rates go up above 6%, you pay me. If they fall below 6%, I pay you. We choose the fixed rate so the total expected value of the payments is zero.

I'm sure you are wondering why anyone would do this. In the 1980s, most bonds in Europe were floating rate. This meant that a company with assets that had a fixed return could get in trouble if rates went way up. The cost of borrowing could eat away at their profits. They would prefer to have a fixed rate loan -- so they could lock in the profit.

In the USA, the opposite was true. Most bonds were for a fixed interest rate. That meant that companies (like Banks) with variable rate liabilities were in trouble if rates increased dramatically. The two companies found that if they swapd their debt for the other company's debt -- both would be better off.

That was the start of the market. The economics behind the market have changed, but they are useful financial instruments for people who want to manage interest rate risk.