Let us look at interest rate swaps. With basic, plain vanilla interest rate swaps, two parties facing
different types of interest rate risk can exchange interest payments without exchanging their
actual loans. One exchanges a fixed rate payment for a floating rate payment, while the other
exchanges a floating rate payment for a fixed rate payment. When interest rates change, the party
that benefits from a swap receives a net cash payment while the party that loses makes a net cash
The dealers, who handle the swaps, usually require each party to post collateral to cover potential
decreases in value of the position. This reduces the probability or default risk.
Interest rate swaps are marked to market. Banks usually use swaps to manage their rate
sensitivity GAP by changing the characteristics of their securities from variable to fixed interest
rate or vice versa. Changes in the market interest rate mean that one of the parties in the swap
will benefit with increases in interest rates while the other will benefit from reductions in these
rates. When hedging with swaps, if your bank suffers due to an increase in market interest rates,
you will receive a cash payment equivalent to the effect of the change in interest from the other
firm. On the other hand, if your bank benefits from a change in interest rate change in the
market, an equivalent amount of cash is removed from your account and is given to the other
firm. At expiration or maturity of the swap, each of the two participants end up paying exactly
what it agreed on at the creation of the swap.
In summary, when hedging with swaps, banks that lose in the cash market when interest rates
increase will normally benefit from a basic swap if they agree to make a fixed rate payment and
receive a floating rate payment; and banks that lose in the cash market when interest rates
decrease will normally benefit from a basic swap if they agree to receive a fixed rate payment
and make a floating rate payment.
To illustrate the workings of swaps, we must first understand the difference between absolute and
comparative advantages. The idea here is that two firms may face different risks in the variable
and the fixed rate markets. Therefore, if these firms face high risk in the market they like, then
they can enter into swaps to reduce their interest expense. If a company faces lower risk in the
variable than the fixed rate market, it is said to have a comparative advantage in that market.
Consider the following example. We have two firms, A and B. Firm A is a higher risk borrower
than B and, therefore, will pay higher interest rate in all markets. The company with the lower
risk has an absolute advantage as it will pay a lower interest rate. However, when these
companies apply for loans in both variable and fixed rate markets, they are offered the following.