How can borrowers and lenders hedge interest rates by linking debt to a reference rate such as LIBOR

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Interest Rate Swaps

An interest rate swap (IR swap), a party that borrows at a floating rate and a party that borrows at a fixed rate effectively swap their payment responsibilities

Oftentimes the parties dont trust each other, so a bank will place itself in the middle, receive and pass on each of the swap payments, and take a small cut in exchange for absorbing the counterparty riskthe risk of one of the parties defaulting on its obligation. The party with the fixed-rate obligation pays the party with the floating-rate obligation a floating rate, and the party with the floatingrate obligation pays the party with the fixedrate obligation a fixed rate. The net effect is that their exposures are switched

Interest Rate Futures

A prominent version of interest rate futures relies on LIBOR USD 3 month, and is called a eurodollar future. Eurodollars are just U.S. dollars that are deposited in banks outside the United States for a fixed period of time Futures are traded on an exchange, which acts as an intermediary between the two firms and absorbs the counterparty risk, much as banks sometimes do with IR swaps. If the uncertainty of future interest rates adversely affects youeither because you need to borrow or lend money or because youve already borrowed or lent money at a fixed ratethen you can lock in those future rates with interest rate futures.

. A firm that knows it will need to borrow money starting in six months could buy eurodollar futures with a settlement date in six months. Then if LIBOR becomes more expensive than expected (the rate is higher), the firm earns money from the futures contract but its loan is more expensive. If LIBOR is cheaper than expected, then it gets a better deal on the loan but loses money on the LIBOR contract.

Forward Rate Agreements

Forward rate agreements (FRAs) are closely related to both interest rate futures and interest rate swaps.

An FRA, one party pays a fixed interest rate, determined in advance, and the other pays a floating interest rate equal to the reference rate at some effective date. Time is the main concern in the fra and because it is not traded at exchange there is counterparty risk.