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Interest Rate Swap

Interest rate swaps are agreements between two parties to exchange interest payments, without ever exchanging the underlying principal amount. These agreements are traded in the over-the-counter (OTC) derivatives markets and can be structured with two sides exchanging either a fixed rate for a floating rate, or vice versa. As interest rate swaps are entered into for a variety of reasons on a forward contract basis, the notional amount specified in the swap agreement is never involved. Instead, the cash flows which occur as a result of the swap are based solely on the difference in each of the parties’ respective interest payments.

Interest rate swaps have become a widely used hedging tool, as they are advantageous for both parties involved in the exchange of cash flows. By entering into an interest rate swap, one party can exchange a higher interest rate for a lower interest rate, while the other party can exchange a lower rate for a higher rate. Additionally, these derivatives have become a common investment strategy, as they allow investors to gain exposure to interest rate fluctuations with less risk than traditional investments in debt securities.

As with any other derivative instrument, interest rate swaps contain the risk of counterparty default. To mitigate this risk, both parties to the agreement typically enter into a credit default swap or other hedging contract to limit their potential losses should the other counterparty default. Moreover, both parties to an interest rate swap typically post collateral to one another to ensure that any changes in the swap contract are adjusted in accordance with its terms.

In summary, interest rate swaps are forward contracts used to exchange one stream of interest payments for another based on a specified notional amount. These swaps allow parties to reduce or increase their exposure to interest rate fluctuations, hedge their risk, and make investment decisions. However, they are not without risks, as counterparty default and collateral requirements are always a possibility.

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