Interest Rate Swaps

This chapter shows how plain vanilla interest rate swaps can be used to convert uncertain future floating-rate interest cash flows into known fixed-rate cash flows. It examines the role of swap dealers, settlement procedures, pricing schedules and the termination of swap agreements. By using the swap, Microsoft has transformed an initial floating rate loan with Citibank into fixed rate payments at 6.5%. Microsoft effectively has the equivalent of a fixed rate loan. One reason for undertaking a swap is that some firms find it cheaper to borrow at say floating rates and use a swap to create the effective fixed rate payments that they really want. Interest rate swaps are undertaken because there are net reductions in the cost of borrowing for both parties to the swap. The principle of comparative advantage allows all parties to the swap to obtain their desired cash flows, at a lower cost than borrowing directly in their preferred form.