Rate swaps are agreements between two separate parties. With these agreements, the parties can
exchange certain cash flows for a specific period of time. Typically, the cash flows are determined by
random variables like interest rates, equity prices, commodity prices, or foreign exchange rates.
Unlike options and futures, these swaps are not instruments that are exchange traded. Instead, they are
custom contracts organized between private parties over-the-counter. In general, the majority of swaps
occurs on the market between corporations, firms, and financial institutions.
There are two basic types of swaps. Today we are going to discuss the most common of the two: plain
vanilla interest rate swaps.
Plain Vanilla Interest Rate Swap
The simplest type of swap available on the market today is known as a "plain vanilla" swap. With this
swap, one party agrees to pay another party a fixed and predetermined interest rate on a security for a
specific amount of time. At the same time, the second party agrees to pay the first party a certain
amount of money for a floating rate of interest for the same security and the same amount of time. The
two separate cash flows are paid with the same type of currency.
The dates that each payment is made are known as settlement dates and the time between each of
these dates are known as settlement periods. The dates for each swap can vary, requiring monthly,
quarterly, or even annual settlement dates. All of this information is typically tracked using rate swap
Why Use a Swap?
There are two basic reasons an individual or corporation might wish to use a swap:
Commercial needs- When a business operates, there can be times when certain kinds of interest
rates or exposures to currency occur. Rate swaps can eliminate these exposures. For instance, if a bank
pays a floating rate on their deposits, or liabilities, and receives a fixed yield rates on their loans, or
assets, they may have difficulties because of the mismatch that occurs between their liabilities and
assets. By using a rate swap to obtain a fixed interest rate for their liabilities and a floating rate for their
loans, they may end up paying less and receiving more from their interest.
Comparative advantage- With some companies, certain types of financing produce a comparative
advantage. However, the kind of comparative advantage received may not be the one they desire. If this
is the case, they can use a rate swap to convert the advantage to a type of financing they want. Most
often one that is more profitable.