Interest Rate Swaps

Question 1

definition

Answer 1

• Two parties exchange one stream of interest payments for another (specified principal amount)
  
  • Typically, one party pays a fixed interest rate, while the other pays a floating interest rate that changes over time (e.g., LIBOR)
  • Allows parties to manage their exposure to fluctuations in interest rates.

Question 2

Key types

Answer 2

1. Fixed-for-Floating Swaps (most common): one party paying a fixed interest rate and receiving a floating interest rate, typically a benchmark (LIBOR/SOFR)
2. Floating-for-Floating Swaps: Both parties pay floating rates but based on different benchmarks.
3. Fixed-for-Fixed Swaps: Though rare, some swaps involve the exchange of two fixed interest rates, usually in different curren

Question 3

uses and benefits

Answer 3

• Hedging: Companies use interest rate swaps to manage exposure to fluctuations in interest rates. For example, a company with a floating-rate loan might enter into a swap to exchange its floating-rate payments for fixed-rate payments, thereby stabilizing its interest expenses.
• Speculation: Investors might use swaps to speculate on future movements in interest rates.
• Arbitrage: Financial institutions might use swaps to take advantage of discrepancies in interest rate expectations in different markets.

Question 4

risks

Answer 4

• Credit Risk: The risk that the counterparty may default on its obligations.
• Market Risk: The risk of losses due to adverse movements in interest rates.
• Liquidity Risk: The risk that a swap may not be easily tradable or that closing out the position might be costly.