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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 .
so a bank will place itself in the middle. The net effect is that their exposures are switched . Oftentimes the parties don’t trust each other. and the party with the floatingrate obligation pays the party with the fixedrate obligation a fixed rate. and take a small cut in exchange for absorbing the “counterparty risk”—the risk of one of the parties defaulting on its obligation. receive and pass on each of the swap payments. The party with the fixed-rate obligation pays the party with the floating-rate obligation a floating rate.
and is called a eurodollar future. If the uncertainty of future interest rates adversely affects you—either because you need to borrow or lend money or because you’ve already borrowed or lent money at a fixed rate—then you can lock in those future rates with interest rate futures. . much as banks sometimes do with IR swaps.Interest Rate Futures A prominent version of interest rate futures relies on LIBOR USD 3 month.S. dollars that are deposited in banks outside the United States for a fixed period of time Futures are traded on an exchange. Eurodollars are just U. which acts as an intermediary between the two firms and absorbs the counterparty risk.
Then if LIBOR becomes more expensive than expected (the rate is higher). If LIBOR is cheaper than expected. the firm earns money from the futures contract but its loan is more expensive. . . 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 it gets a better deal on the loan but loses money on the LIBOR contract.
determined in advance. and the other pays a floating interest rate equal to the reference rate at some effective date.Forward Rate Agreements Forward rate agreements (FRAs) are closely related to both interest rate futures and interest rate swaps. one party pays a fixed interest rate. An FRA. Time is the main concern in the fra and because it is not traded at exchange there is counterparty risk. .