In this way, corporations could lock into paying the prevailing fixed rate and receive payments that matched their floating-rate debt. Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities by allowing them to pay fixed rates, and receive floating-rate payments. This is how banks that provide swaps routinely shed the risk, or interest rate exposure, associated with them. If a swap transaction is large, the inter-dealer broker may arrange to sell it to a number of counterparties, and the risk of the swap becomes more widely dispersed. After a bank executes a swap, it usually offsets the swap through an inter-dealer broker and retains a fee for setting up the original swap. The counterparties in a typical swap transaction are a corporation, a bank or an investor on one side (the bank client) and an investment or commercial bank on the other side. Investment and commercial banks with strong credit ratings are swap market makers, offering both fixed and floating-rate cash flows to their clients. Although there are other types of interest rate swaps, such as those that trade one floating rate for another, vanilla swaps comprise the vast majority of the market. LIBOR is the benchmark for floating short-term interest rates and is set daily. The most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate payments for floating-rate payments based on LIBOR (London Inter-Bank Offered Rate), which is the interest rate high-credit quality banks charge one another for short-term financing. Swaps are derivative contracts and trade over-the-counter. Swap spread: The spread paid by the fixed-rate payer of an interest rate swap over the rate of the relevant sovereign bond with the same maturity as the swap.Īn interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time.Over-the-counter: A security traded in some context other than on a formal exchange such as the New York Stock Exchange (NYSE) and London Stock Exchange (LSE).London Interbank Offered Rate (LIBOR): The posted rate at which prime banks offer to make Eurodollar deposits available to other prime banks for a given maturity which can range from overnight to five years.Liability Driven Investing: A form of investing in which the main goal is to gain sufficient assets to meet all liabilities, both current and future.Interest rates are influenced by a variety of factors, including economic growth, inflation and supply/demand. Interest Rates: The percentage paid as a fee for the use of money, expressed as an annual percentage of the principal amount.Similarly, when interest rates decline, the market value of fixed income securities increases. Interest rate risk: When interest rates rise, the market value of fixed income securities (such as bonds) declines.Interest: An amount charged to a borrower by a lender for the use of money, expressed in terms of an annual percentage rate upon the principal amount.Inter-dealer broker: A broker who acts as an intermediary between dealers in government securities.Floating-rate payments: Interest payments that periodically change according to the rise and fall of a certain interest rate index or a specific fixed income security which is used as a benchmark.Fixed-rate payments: Interest payments that remain the same amount for the entire term of the security or contract.Fixed-rate bonds: A bond that pays the same amount of interest for its entire term. Duration: A measure of the sensitivity of the price of a bond to a change in interest rates.Derivative: A security which derives its value from movements in an underlying security, such as stocks, bonds, commodities, currencies and interest rates.Counterparty risk: The risk to each party of a contract that the counterparty will not live up to its contractual obligations.Central Counterparty (CCP): A clearing house that interposes itself between counterparties to contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer and thereby ensuring the future performance of open contracts.Credit risk: The risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay loan or otherwise meet a contractual obligation.
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