8. April 2021
Interest rate swaps are traded over the counter and if your company decides to exchange interest rates, you and the other party must agree on two main topics: in the case of an interest rate swap, the parties exchange cash flows on the basis of a fictitious capital (this amount is not actually exchanged) to hedge or speculate against interest rate risks. Imagine, for example, that ABC Co. has just issued $1 million of five-year variable annual bonds, defined as the London Interbank Offer Rate (LIBOR) plus 1.3% (or 130 basis points). Let`s also assume that LIBOR is 2.5% and that ABC management is concerned about an interest rate increase. From the fixed-rate taxpayer`s point of view, the swap can be considered to have opposing positions. In other words, commodity trading involves the exchange of fluctuating commodity prices, such as Brent Crude Oil Spotprice, for a price set over an agreed period. As this example indicates, crude oil is most often used for commodity swets. A credit risk swap (CDS) consists of an agreement entered into by a party to pay the lost principal and interest on a loan to the buyer of CDS when a borrower is defaulted with a loan. Excessive leverage and mismanagement of risks in the CDS market were one of the azusotoligal causes of the 2008 financial crisis. The theory is that one party can hedge the security risk, which offers a variable interest rate, while the other can use the potential reward while holding a more conservative asset. It`s a win-win situation, but it`s also a zero-sum game. The profit that one party gets from the swap is the loss of the other party.
While you neutralize your risk, one of you will lose some money. Unlike most standardized options and futures, swaps are not exchange-traded instruments. Instead, swap contracts are bespoke contracts negotiated between private parties on the over-the-counter market. Businesses and financial institutions dominate the swap market, and few (if at all) individuals participate. Because swaps take place in the over-the-counter market, there is always a risk of a counterparty defaulting. The most traded and liquid interest rate swaps are referred to as zero-rate swaps, in which variable rate payments are traded on the basis of LIBOR (London Inter-Bank Offered Rate), i.e. high-risk credit banks that calculate each other for short-term financing. LIBOR is the benchmark for short-term interest rate fluctuations and is set daily.