Arbitrage, Speculation and Hedging

International Finance According to Investopedia, interest rate swaps are OTC-traded contracts between two parties, whereby the two parties agree to exchange the future interest payments related on a principal amount This exchange usually implies that the parties exchange a fixed payment for a floating payment, in other words, a fixed interest rate for a floating interest rate. While this is the most current form of interest rate swap, all the other combinations of fixed vs.

floating (floating for floating and fixed for fixed, as well as floating for floating with different currencies) are also present in such exchanges. As mentioned, one of the most common forms of interest swaps is the fixed-for-floating rate swap. In this situation, one of the parties pays its fixed interest rate to the other party. In exchange, the first party receives the floating rate, which is usually an interest calculated around a reference rate, such as LIBOR or EURIBOR (of the type LIBOR + 1%, for example).

The former is called the payer, while the latter is called the receiver. As a consequence of this interest rate swap, the payer can now borrow on the market at a floating rate, namely the reference rate plus percentage (instead of the fixed rate it initially had). The receiver can now borrow on the market at the fixed rate, instead of the floating rate. Primarily, interest rate swaps are used either for speculative or hedging motivations.

Those who exchange the floating rate for a fixed rate believe that the reference rate will rise to the degree to which a fixed rate is preferred and provides a lower cost than a floating rate. Those who prefer a floating rate believe the reference rate will fall,.