In times of recent financial struggle, interest rate swaps are on the increase, and not just in the UK, but worldwide. An interest rate swap is an OTC clearing method that is used by a London clearing house to swap two different interest rates. Two firms will agree to make payments to one another over a specified amount of time, the time period generally being based on the amount if interest. A future interest payment is swapped for another and the method is used by those who wish to swap a flexible interest rate for a fixed one and vice versa.
The benefits of these swaps are quite profound, and it is easy to see why such swaps are on the increase in times of recession and financial ruin for many. When the two companies agree on a Swap rate, they will decrease their exposure to adverse interest rates and they will decrease their overall costs. Sometimes, not only can costs be reduced but the firms can make a profit by swapping their interest rates, making it a very important subject to understand as an investor.
Most investors use an interest rate swap to manage risk, the most common type of swap being known as a plain vanilla swap. This type of swap allows two firms to swap a fixed rate and a floating rate interest rate, the swap being based on the LIBOR. The LIBOR handles the floating rate market, these values changing on a daily basis. Such swaps are simple, and they will not affect a business on paper, no money changing hands with the coupon as the interest rate is nothing more than a notion.
Swapping interest rates allows the companies to match their liabilities with their incomes, the primary reason for swaps being the lowering of rates to help the borrower manage debt. One of the firms involved in the swap will generally be a financial entity, and a huge percentage of derivatives trading now being through plain vanilla swaps. Banks have been known to make huge amounts of money by buying fixed rate interest rates, JP Morgan Chase having made 1.4 billion dollars in revenues by swapping and trading.
The trend of OTC clearing and interest rate swaps is becoming more and more popular as investors are realizing the full potential of the method. When a plain vanilla swap contract is drawn up, cash flows over a period of a few years can be worth millions of dollars to the correct investor.
Rate swaps, and plain vanilla swaps are a method of managing debt without having to refinance or indeed pay out or lose huge amounts of cash. When a business is struggling, it will most likely have a low credit rating, and this in turn means that many financial institutions will charge heavily for refinancing debt. Interest rate swaps will allow the company to swap notional amounts of cash, paying only a small fee to the commercial investor instead of losing out heavily when trying to manage the debt.