In regards to a ‘vanilla’ rate swap, given the variable rate is subject fluctuation how is the lender entering into the swap benefitting? Are they hedging there bets that the variable rate will be lower than the fixed rate they are owed by the borrower?
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– Interest rate swaps are agreements between two parties to exchange payments based on different interest rates for a certain amount of money and a certain period of time.
– For example, Party A has a loan with a variable interest rate that changes every month based on a market index, like LIBOR. Party B has a loan with a fixed interest rate that stays the same for the whole term of the loan.
– Party A and Party B decide to enter into an interest rate swap, where Party A agrees to pay Party B the fixed interest rate on the same amount of money as their loans, and Party B agrees to pay Party A the variable interest rate on the same amount of money as their loans.
– The swap does not affect the original loans, which the parties still have to pay to their respective lenders. The swap is a separate contract that only involves the exchange of interest payments between the parties.
– The lender entering into the swap is benefiting by receiving a fixed interest rate that is higher than the variable interest rate they are paying to their borrower. They are hedging their bets that the variable interest rate will be lower than the fixed interest rate they are owed by the borrower.
For example, if the fixed interest rate is 5% and the variable interest rate is 3%, the lender will receive 5% from Party A and pay 3% to their borrower, making a net profit of 2% on the swap. If the variable interest rate rises above 5%, the lender will lose money on the swap, but they will still receive the fixed interest rate from their borrower, so their overall income will not change.
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