Interest rate swaps allow traders to ‘swap’ the cash-flows of interest-rate bearing financial instruments. For example, Trader A owns a floating rate at five percent on a $10,000 nominal investment but would prefer to lock in a fixed rate whilst still owning the investment.

The Interest Rate Swap | IRSA

Plain vanilla interest rate swap. To achieve the preference, Trader A exchanges interest rate cash flows with Trader B. This transaction is an illustration of a “plain vanilla swap,” according to author Howard Corb (“Interest Rate Swaps and Other Derivatives,” 2012). A plain vanilla swap is usually not immediately profitable for either trader. The traders have a perspective about interest rates. Trader A would rather lock in cash flow. He may believe that interest rates are going lower over a period of time. Conversely, Trader B believes that interest rates are going higher. He would rather own a floating rate instrument to take advantage of higher future rates.

Fixed interest rate swaps in different currencies. Fixed interest swaps can include an exchange transacted in different currencies, writes Felix Lessambo (“The International Banking System,” 2013). For example, Company A trades cash seven percent cash flow on $100,000 in USD with Company B’s current euro-equivalent of USD 100,000 at seven percent. If the euro increases in relative value against the dollar over the period of the interest rate swap, Company B will make money.

If the foreign exchange rate is .70 USD equals 1 euro, Company B’s nominal investment is initially valued at €70,000 and €4,900 in interest at seven percent. If the forex rate declines to .60, the original investment does not change. However, the interest cash flow on the investment rises in value even though the euro strengthens against the USD by .10.

Interest rate swaps and currency risk. Interest rate swaps can protect a company against currency risk, as shown in the above example. If an import-export company has concerns about relative currency value changes on the foreign exchange trading market, a fixed interest rate swap traded in different currencies can help. Of course, the company must trade for increasing, incoming cash flow (greater in value than the outgoing cash flows for which it trades). Because exchange rates float in the international forex markets, the traders of any interest rate swap cannot predict future currency rate movements with certainty.

Interest rate swap types. Traders use several types of interest rate swap structures for different interest rate exchange scenarios. As described above, Traders A and B exchanged a plain vanilla swap. This swap exchanged cash flows of a fixed rate instrument for a variable or floating rate instrument. The second example shows a simple currency swap, as interest rates and principle remain fixed but foreign exchange rates float. A third interest rate swap type is transacted between financial agents or banks. According to Jawwad Ahmed Farid, (“Derivatives: Pricing Interest Rate Swaps,” accessed 2013) swaps known as rate-capped or base swaps. Base swaps trade floating interest cash flows rather than fixed rates or in a combined fixed-floating format; rate-capped swaps limit the floating rate’s fluctuation potential (e.g., ‘caps’ how high the rate may change) before an interest rate-based cash flow may no longer rise or fall. These, and other customized interest rate swaps, help traders to hedge underlying portfolios or trade with a certain perspective in the interest rate markets.

Interest rate market size. According to author Corb, the Bank for International Settlements (BIS) says the interest rate swap market is enormous. BIS calculated the aggregate OTC (over-the-counter) interest rate swaps and options market at greater than USD 400 trillion notional (‘fictitious principal’) at year-end 2010. The interest rate swaps market assists traders in hedging underlying portfolios from interest rate and/or currency risks. Swaps are commonly used by large financial institutions, hedge funds, insurance companies, corporations or government-related organisations with a desire to take a market perspective or as part of a risk management program.



Maple Financial Interest Rate Swaps

We have a specialist team of solicitors dedicated to dealing with the mis-selling of interest rate swap protection products by the banks. We are very happy to review these relatively complex arrangements and to claim compensation for our clients where appropriate.

If you believe you have incorrectly been classified as a ‘sophisticated’ customer and have, therefore, not been eligible for redress.  Maple Leaf Financial swap claims will review your interest rate product and we will be happy to discuss your individual concerns and requirements : 0800 7747624



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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.