An interest rate swap is a form of derivative in which two parties exchange the interest rates that they hold on securities such as stocks and bonds.
Usually, the interest rate swap is used in cases where one party holds a fixed-rate interest on a security, while the other has a variable interest rate, and for one reason or another each party would prefer to have the other type of interest rate.
In theory, when transacting an interest rate swap, one party is able to hedge their bets on the risk of the security they own while the other party can secure a more conservative position on their asset. This makes the interest rate swap an interesting transaction, because while it is a win-win for both parties, as each participant secures their desired position, it is also a zero-sum gain. In other words, the amount that one party gains is equal to the amount that the other party loses. Despite the fact that both parties know that one of them will lose out on the trade, each one feels that their preferred position is more secure.
When a business decides to exchange interest rates with another securities holder, both parties will need to decide on some parameters; first of all, the length of the swap. This establishes the start date and the maturity date for the exchange and both parties will be bound by the agreement until it expires. Other considerations include how frequently you want payouts to be. Usually this will be monthly, quarterly, or annually.
Interest rate swaps can be used to great effect by savvy businessman, but deploying them effectively requires one to familiarize themselves with how interest rate swaps work. So, what are the advantages that interest rate swaps offer to businesses?
Cutting the Risk of Speculation
This is of particular interest to hedge funds and other businesses that are dependent upon speculation to make their money. There are certain inherent risks that come with such ventures. These cannot be avoided entirely, but interest rate swaps are one way of mitigating the risk.
There are other methods that can be used to achieve this, but the interest rate swap has the advantage of not sacrificing too much of the potential rewards that a business could potentially obtain on their security.
Taking Advantage of Market Fluctuations
The interest rate swap is most effectively used by businesses that have a high level of expertise in the forecasting of future interest rates. By being savvy about the way you use these talents to speculate, you can make massive profits by engaging in both high-rate, and high-volume swaps.
Matching Revenue Streams to Liabilities
Banks are legally required to maintain revenue streams which match their liabilities in order to ensure that they are resilient to shockwaves in the market. Consider a real world example; a bank is paying a variable interest rate on the liabilities it has on the securities it holds, meanwhile it is receiving fixed payments on any loans it is paying out. In this case the bank is facing a great deal of risk due to the variable rate liabilities, swapping the fixed rate interest rate it holds on its loans for a variable rate that offers a higher return allows the bank to hedge its bets against this risk. By doing this, banks can ensure that their revenue will be greater than their expenses and they will therefore be protected from a crunch in the market.
In order for your business to take advantage of interest rate swaps, whether they are used to secure a more favourable position on the market and minimize the risk of any investments they hold, or to take advantage of market fluctuations to profit from the trade. This can be used to make businesses more resilient to market stocks or to make an informed investment. It is worth having at least one person on your team with experience in speculating on the markets.