Interest Rate Swaps

The word “swap” means to exchange. So, if two companies swap machines, they are trading those machines for each other. In the context of interest rate and foreign currency swaps, two companies are choosing to exchange the interest that they are paying (or receiving) or to exchange the currency that they are paying or receiving.

Interest Rate Swaps

Interest rate swaps are contracts between two parties that agree to trade payment streams, specifically interest payments on debts. The most common form involves one payment at a fixed rate and one at a floating (or variable) rate pegged to some market rate of interest that changes whenever the market rate changes.

The primary purpose of an interest rate swap is to match the characteristics of a firm’s revenue stream with the characteristics of its payment stream. For example, if a firm has a revenue stream that is fixed but a payment stream that increases and decreases with market interest rates, the firm would want its payment stream to be fixed if management believes interest rates are going to increase.

Users of interest rate swaps include large companies and financial institutions, such as commercial banks, hedge funds, and pension plan managers. An interest rate swap enables an entity to change the terms of the interest payments on its borrowings (from floating to fixed or from fixed to floating interest rates) without having to renegotiate the borrowings. For example, an interest rate swap enables a bank to limit its risk of the decreased profitability that will occur if interest rates do what it expects them to do.

A hedge fund is a pooled investment fund that uses aggressive investment strategies in an effort to earn high returns for its investors. Hedge funds in the U.S. are open only to “accredited investors” (high net worth or high income investors), and they are subject to less regulation than are mutual funds that are open to all retail investors. Although hedge funds have outperformed the market at times, many other times they have underperformed the market for their investors. Hedge funds have high fees, and the high fees negatively impact investors’ returns.