In economics, an interest rate swap is a financial interest rate derivative. It essentially involves the transfer of interest rates between two involved parties. In particular, it is usually a “zero-coupon” IRD, and among the most stable, mainstream financial products. It also has a significant association with forward rate arrangements, and even with zero-coupon deals.
In simple terms, an interest rate swap means that the holder of a bond or note exchanges the current interest rate for one whose rate is lower. In this process, the bonds or notes are called collateral. In some cases, this collateral may be “call options”, since it gives the holder the option to buy a certain amount of time (the expiration date) at a certain price (the strike price). For instance, if a person holds a call option to sell a bond at three percent interest, then when the option expires, the holder can choose to exercise his right to sell at zero percent interest. This option gives him the freedom to speculate on the direction of interest rates.
Swap income tax treatment is the basic concept of how interest rates are traded on the market. However, there are other factors affecting interest rates, especially when the central bank of a country is changing its interest rate policy. For instance, in a tightening economic cycle, banks are more likely to tighten the credit standards they have been applying to new loans. This is why many times the term “sterilized bond interest rate” is used to describe these instruments. A different type of this financial instrument exists, which trades interest rates simultaneously with the base interest rate.
In general, it is easier to trade interest rate swaptions on interest rates, rather than to trade bonds. This is because it does not involve any risk of losing cash. The risk exists only with the interest rate. The interest rate swap allows investors to pay an interest rate in a lump sum to another party. However, it must be noted that a central bank must offer such a facility and the borrower must accept it.
Swap transactions are usually entered into by borrowers who do not want to change their long-term interest rate commitments. It is common for commercial borrowers to enter into a swap transaction to lock the interest rate at a lower level than they would otherwise agree upon. Borrowers may also opt to swap their obligations for shorter terms, which can lead to large interest savings. A person may buy a bond that has a longer-term commitment and then borrows a different rate of interest to replace the bond, and then sell the bond to repay the initial loan.
A reverse mortgage is a great example of a long-term interest rate swap where the mortgage holder is able to take advantage of lower interest rates when the homeowner retires. The mortgage holder will receive a lump sum of money when retirement comes and the mortgage is paid off completely. In many cases, the interest rates do not change, but they could vary depending on which institution is offering the reverse mortgage.
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