An interest rate swap is a type of derivative that allows two companies to exchange interest payments.

The firms exchange interest cashflows over a predetermined time period and amount of principal.
Although there are instances where a firm uses swaps to speculate about interest rate movements, they
are typically done to achieve a firm’s goals of borrowing at a fixed vs floating interest rate which it is
unable to obtain at favorable rates without the swap.

Firms engage in swaps to hedge against interest rate risk. A firm may consider engaging in a swap if it is
exposed to either fixed or floating interest rate risk. This allows the firm to achieve a desired ratio of
fixed and floating rates on its outstanding debt. It may also use swaps to exchange cashflows that can
more accurately match its operational cashflows. For example, a firm with a cyclical business or coming
capital expenditure needs may prefer one type of interest rate so as to meet these expenditures.
Specifically, a bank may need to match short-term deposits which they use to fund their longer-term
loans and look to swap the fixed rates from the loans. This would allow them to mitigate risk if rates rise
in the near term and they are forced to pay more for deposits, which is what is currently happening.

One point to note is that although firms can hedge interest rate risk with swaps the swap itself exposes
the firms to counterparty risk. Since swaps are primarily facilitated over the counter, there is no
exchange backing and a firm needs to mitigate its counterparty risk by carefully vetting which firms it
agrees to swap rates with.

Hi Cody,

Nice job on your discussion of interest rate swaps. I appreciated that it was clear and easy to follow.
Your inclusion of how the subject applies to you work as a credit analyst is helpful in allowing others to
understand the application of these topics outside in actual situations. The insurance policy analogy is a
nice addition allowing for someone to relate the topic to something else they might understand. Overall,
a good job on your discussion.

Hi Maria,

Good job laying out the different types of interest rate swaps that firms could engage in. Firms have
different goals and cashflow situations and engage in various types of swaps to meet their specific needs.
You had a nice addition about hedging and how it can be used to limit financial risk, these interest rate
swaps are just another tool firms can use to mitigate these risks. Again, nice job on a clear and
informative discussion.