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Hedging Interest Rate Risk Using Interest Rate Swap

Hedging Interest Rate Risk Using Interest Rate Swap

Interest rate swaps allow companies to exchange interest payments on an agreed notional amount for an agreed period of time. Swaps may be used to hedge against adverse interest rate movements or to achieve a desired balanced between fixed and variable rate debt.

Interest rate swaps allow both counterparties to benefit from the interest payment exchange by obtaining better borrowing rates than they are offered by a bank.

Interest rate swaps are arranged by a financial intermediary such as a bank, so the counterparties may never meet. However, the obligation to meet the original interest payments remains with the original borrower if a counterparty defaults, but this counterparty risk is reduced or eliminated if a financial intermediary arranges the swap.

The most common type of swap involves exchanging fixed interest payments for variable interest payments on the same notional amount. This is known as a plain vanilla swap.

Interest rate swaps allow companies to hedge over a longer period of time than other interest rate derivatives, but do not allow companies to benefit from favourable movements in interest rates.

Another form of swap is a currency swap, which is also an interest rate swap. Currency swaps are used to exchange interest payments and the principal amounts in different currencies over an agreed period of time. They can be used to eliminate transaction risk on foreign currency loans. An example would be a swap that exchanges fixed rate dollar debt for fixed rate euro debt.

Source: Ken Garrett, ACCA

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