Interest Rate Swaps: Dangerous Derivative or Effective Tool?

Recently there have been numerous articles noting the losses sustained by institutions utilizing interest rate swaps. As a result, the whole area of derivatives has been tainted by much negative publicity. This is not deserved, and seems to have been the result of the misuse of the instrument for speculation, rather than risk insurance purposes.

The following is intended to “demystify” interest rate swaps and demonstrate their use as interest rate risk and rate reduction instruments.

As is widely known, an interest rate swap is a contractual arrangement whereby a debtor converts one form of interest obligation for another. The market for interest rate swaps is based on at least two major factors. One if the existence of financial markets with different characteristics, particularly the format of interest rate payments. One market is the traditional short term floating rate market based on periodically resetting a debtor’s interest rate based on LIBOR, one benchmark rate in this market, and the lender’s cost of funds as a rule. The other major market is the public and private fixed rate market, in which rates are set at a specified rate for the life of the loan. The benchmark rate in this case is the comparable Treasury note rate. Rates are set based on the credit of the borrower at some premium over the U.S. Treasury obligation of similar maturity.

This is only an excerpt of Interest Rate Swaps: Dangerous Derivative or Effective Tool?

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