Interest rate swaps are common especially with large financial institutions. Swaps are mostly unregulated and do not trade on public exchanges but as over-the-counter derivatives. Most members of the public do not know about Swaps.

Interest rate swaps are agreements between institutions to exchange cash flows. However, in some swaps, the difference is not in the interest rate but the currency. In practice, interest rate swaps are more complicated and may involve a simultaneous variation of interest rates, currencies and other variables.

Interest rate, also known as swap rate, has a close relation with prevailing interest rates applied to a country’s currency deposited in other institutions that do not belong to that country. Swap settlement is implemented with the exchange of would-be payments from two parties rather than the principal.

Types of Interest Rate Swaps

Trading Swaps

Generally, there are three steps involved when trading swaps. The first step is making a choice on the maturity date. This is referred to as picking a point along the yield curve.

Interest rate swaps have a tendency to vary depending on the maturity. The second step is to determine the vehicle that is being hedged out. The third step is choosing the direction of the trade.

Parties hedging against an increase in interest rate swaps will make different trades than those expecting lower rates. There will also be a difference in how parties trade when they expect too much exposure on a single currency. Once the three steps have been followed, determining the value of a swap in money markets and futures contracts is a completely new game.

Benefits of Interest rate Swaps

Avoid Foreign Exchange Controls
Many countries regulate currency swapping to boost their domestic economies, keep currencies in their country and avoid devaluation. The regulations determine how much a trader can exchange for a foreign currency.

Multinationals developed interest rates swaps as a means of preventing foreign exchange controls. This allows traders to trade interest rates from one form of currency to another. Interest rates swaps provide businesses the opportunity to raise capital in a foreign market without extending their debts in the foreign country.

Speculative Investment
Speculative investors depend on fixed-rate swaps as a tool for placing bets on interest rate fluctuations. During the initial structuring of an interest rate swap, the commitment of each party is valued the same. As the interest rates change, the value of the interest rate swap also adjusts with rate changes. This makes the floating-rate payment amount go up or down according to the market forces. When traders believe interest rates will fall, they look to exchange floating rates for fixed rates. On the contrary, if speculators predict a rise in interest rates, they exchange fixed rates for floating rates.

Risk Management
Many investors with large holdings in floating-rate investments use interest rate swaps to take off the risk from some of their portfolios. They do this by trading floating-rate investments for secure fixed-rate ones. This helps the investors to get a measure of stability that floating-rate investments cannot offer. Investors use the gains offered by fixed-rate mechanisms as a reliable tool for managing their investments.

Businesses use swaps when the parties in a swap can access debts that the other cannot. For example, companies that need fixed interest rate but can only access floating interest rates can swap with other companies in the converse situation.

Cost
Large businesses use interest rate swaps to lower costs. Swaps are cost effective because they have fewer fees than other forms of debts. The cost effectiveness of swaps can be improved further if cash-outflow costs are offset by advantages of a variable inflow that is half of the swap.

Many companies look into interest rates when they have a combination of liabilities that charge interest rates and assets that pay fixed interest rates. When a company swaps with that on the opposite side, it is in a position to manage its capital to match up expenditures.

Profit
Interest rate swaps from fixed and variable rates help maintain company profits when interests on debts increase. The profits can be higher if cash outflows remain fixed. As the variable rate rises, the profitability of the interest rate during the period also increases. Though this practice is mostly speculative, it contributes to lower project management costs and higher returns.

Typical Interest Rate Swap Terms
Two parties negotiate and, depending on current economic conditions and interest rates, one of the parties will have to pay above the usual rate to get the deal done. The two parties set the duration of the swap, which may vary from 1-15 years. Settlements dates are then set after which the settlement period begins.

Settlement Dates
This refers to the period when the settlement period ends and the party whose end of the swap loses starts to pay up. Typically, no money changes hands until the settlement period ends. During the settlement date, the party with a higher interest collects the difference from the one with a lower interest.

Interest Rate Swaps Basics

With fluctuating economies and different trends in the financial sector, many creditors and financial institutions are using interest rate swaps to meet the demands of the changing investment climates. However, lenders may be losing on the opportunity to make money due to unnoticed swaps. Here are tips on how to discover swaps and prevent losses when trading.

• Know the terms of the swap agreement. Traders should find out what are the applied interest rate and the terms set to determine how and when original interest rates are swapped for larger ones i.e. what may cause an increase in the interest rate. Once the trigger factors have been determined, traders should request immediate verbal notification. By law, traders have a right to receive a written notification of an interest swap.

• Find out if a generic fixed-to-floating interest rate at a line of credit or start of a loan was assigned. Fixed rates cannot be changed unless borrowers are subject to prepayment or non-payment swap-based fee. Traders should negotiate for a longer fixed rate period if possible.

• Traders should also know their credit scores. People with high credit scores are less likely to get an interest rate swap than those with bad credit.

• Traders who miss on payments should immediately find out the interest rate determined on their statements or quarterly invoice. Traders should also monitor each line of credit after a decline in the credit score.

Considerations
Parties in a swap trade do not normally complete their swap option agreement directly with each other. Each party in a swap agreement uses a swap account with a bank or broker to complete transactions. The agent’s payment is made by deducting the difference between the sales and offer price levels. Though the spread on a trade may be quite small, it accumulates to an attractive fee when calculated on large notional amounts.

Risks
There are certain risks associated with interest rate swaps. The most notable is that swaps tie up companies’ fortunes into a single investment vehicle. In case one of the parties defaults on payment, the other party loses money. In addition, when company’s fortunes are badly managed, it may create a tough financial situation that may make it default payments. The effects of the payment default can reverberate through the entire market.

Interest rate swaps provide companies the opportunity to work together for mutual benefit. They do this by providing one another access to more affordable debts and by using each other’s rates to hedge against changes in interest rates.

 

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Tim Capper

Bringing you financial news and information in plain english for Maple Leaf Financial. My aim is to help readers understand these often complex financial instruments.