What are interest rate swaps?

21st Nov 2009 by cocacolabuffet

Interest rate swaps are agreements among counterparties to exchange one stream of interest payments with another stream of interest payments. The most common type of interest rate swaps is ¡°plain vanilla¡± swap in which a fixed rate interest payment is exchanged with a floating-rate interest payment.
It is very useful for counterparties to hedge away interest risks. For example, Bank A may pay its depositors floating interest rates on deposits and receives fixed interest rates from mortgage borrowers. Bank A will be hurt by rising interest rates in this case. Bank B may pay its creditors fixed-rate interest rates while receiving a large amount of floating-rate interest income. Bank B will be hurt by dropping interest rates. Both banks can enter into a plain vanilla swap in which Bank A will exchange its fixed-rate interest income for Bank B¡¯s floating-rate interest income. As a result, fixed-rate (floating-rate) interest income is matched with fixed-rate(floating-rate) interest expense in Bank B (Bank A).

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