An interest rate swap is a financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount, over an agreed period of time. Interest rate swaps provide a way for businesses to limit or manage exposure to fluctuations in interest rates.

The most commonly traded interest rate swaps are known as “vanilla” swaps, which are agreements to exchange fixed-rate payments for floating-rate payments based on the London Interbank Offered Rate.

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By convention, the party that elects to receive a fixed rate and pay floating is known as the “receiver,” while the party that receives floating in exchange for fixed is the “payer.” The receiver demands a “swap rate” in exchange for the uncertainty of having to pay the short-term LIBOR over time. At the time of the swap agreement, the fixed swap rate will be equal to the value of expected floating rate payments implied by the market’s forecast of what LIBOR will be in the future. As future expectations for LIBOR change, so will the swap rate that investors demand to enter into new agreements.

For example, a company may have a bond that pays the LIBOR, while the other party holds a bond that provides a fixed payment of 6%. If the LIBOR is expected to stay around 4%, then the contract would likely explain that the party paying the varying interest rate will pay LIBOR plus 2%. That way both parties can expect to receive similar payments. Furthermore, borrowers use interest rate swaps to alter the frequency of their cash flows. Annual interest payments are converted into quarterly payments or quarterly payments into semi annual cash flows. Interest rate swaps are also used speculatively by hedge funds who expect a change in interest rates.

Since they trade over-the-counter, interest rate swaps can come in a huge number of varieties and can be customized to meet the specific needs of the counterparties. This flexibility is why many companies, financial institutions, pension managers and insurers find interest rate swaps as an invaluable tool in managing their asset and liability positions without leveraging up the balance sheet.

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Interest-rate swaps carry two primary risks: interest rate risk and credit risk. Since actual interest rate movements do not always match expectations, swaps entail interest-rate risk. Simply put, a receiver profits if interest rates fall and loses if interest rates rise, while the payer profits if rates rise and loses if rates fall. Swaps are also subject to the counterparty’s credit risk. Although this risk is very low because banks that deal in LIBOR and interest rate swaps generally have very high credit ratings, it is still higher than that of a risk-free U.S. Treasury bond.

The interest rate swaps market, which started decades ago as a way for corporations to manage their debt, has since grown into one of the most liquid derivatives markets in the world. The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market, with the notional amount outstanding in OTC interest rate swaps standing at a staggering $342 trillion as of June 2009. The swap curve is a yield curve comprising swap rates for different maturities, and has also become an extremely important interest rate benchmark for credit markets.

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