What Are the Benefits of Interest Rate Swaps?

Intrest rate swaps are a derivative used by advanced financiers.stock market analysis screenshot image by .shock from Fotolia.com

In an interest rate swap, one party agrees to exchange a fixed-rate payment for another party’s floating-rate payments. These derivatives have become a prominent tool in modern finance, allowing speculators to bank on increased future returns and swappers a means to manage risk and the uncertainties involved with floating-interest rates.

Avoiding Foreign Exchange Controls

To promote domestic economic security by attempting to keep currency in country and avoid devaluation, many countries enforce regulations on currency swapping. These regulations impose limits on how much currency a party can convert to a foreign type. Multinational companies developed interest rate swap mechanisms as a means to circumvent foreign exchange controls, trading interest rates from one type of currency with the type needed. These swaps provide businesses a tool to raise capital in a foreign market without extending debt in that country.

Speculative investors use fixed-rate swaps as a tool to bet on interest rate fluctuations. When an interest rate swap is initially structured, each party’s commitment is valued the same. When interest rates change, the value of the interest rate swap adjusts with rate changes, so that the floating-rate payment amount may increase or decrease with market forces. Speculators who believe interest rates will fall look to exchange floating rates for fixed ones; if they predict rising interest rates they exchange fixed rates for floating ones.

Investors with large holdings in floating-rate investments use rate-swap mechanisms to remove some of the risks from their portfolios. By trading the unpredictable nature of a floating-rate investment for a secured fixed-rate one, investors receive a measure of stability that isn’t afforded by floating-rate mechanisms. These investors use the stability gained through fixed-rate investments as a tool that manages their investments more precisely.