Interest rate swaps, a financial innovation in recent years, are based upon the principle of comparative advantage. An interest rate swap is a useful tool for active liability management and for hedging against interest rate risk. The purpose of this paper is to provide a simple economic analysis of interest rate swaps. Alternative uses of and the appropriate valuation procedure for interest rate swaps are described.
THE SIGNIFICANT INCREASE in both the levels and the volatilities of marketinterest rates since the late 70's has resulted in substantially higher interest-rate risks faced by business firms and financial institutions. The problem and consequences of interest-rate risk exposure are particularly serious for firms in which the duration of assets does not match the duration of the liabilities. For instance, most financial institutions and many corporations financed long-term fixed-rate assets with short-term floating-rate liabilities. Such firms lose when the shortterm interest rates in the market rise unexpectedly, because for given fixed rates of return on their assets, the short-term interest costs that they have to pay rise with the market interest rates. Conversely, these firms gain from an unexpected decline in short-term market interest rates. In recent years, the introduction and the development of new financial products in the capital markets-such as interest rate futures, interest rate options and interest rate swaps-represent logical responses to the increased need to reduce firms' exposure to interest rate risk.Since the early 1980's, interest rate swaps have become one of the most popular vehicles utilized by many companies and financial institutions to hedge against interest rate risk. The growing popularity of interest rate swaps is due, in part, to the fact that the technique is simple and easy to execute. Although there is no published figure showing the exact magnitude of the market value of interest rate swaps, it has been estimated that a total of more than $150 billion of interest rate swaps had been completed in the United States by the end of 1985. Further, the transactions in this market are growing at an astounding rate.The purpose of this paper is to provide a simple economic analysis of interest rate swaps. In Section I, the basic interest rate swap and its economic rationale are briefly discussed. Alternative uses of interest rate swaps are described in Section II. In Section III, the valuation procedure appropriate for interest rate swaps is sketched and a simple comparison of two swaps is presented. The final section provides a brief summary.
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