My work has one of these and it sounds so confusing.
In: Economics
If you’re referring to an interest rate swap, then:
You and I run two separate banks. I make a $1 million dollar loan to someone with the terms that they pay me back with 5% fixed rate interest. You make a $1 million dollar loan to someone where the interest rate is variable and tied to some benchmark, say the 30-Year US Treasury rate + 1%. So every time my client makes a payment, it’s always based on 5%, even if all of a sudden the Treasury rates shoot up. Your customer’s interest rate is recalculated each payment cycle.
Swap loans enable the two of us to trade interest payments on these loans, allowing us to diversify, bet on the market’s future, etc. Swap loans are almost always swapping a fixed for a variable rate or vice versa. So imagine we’re both trying to make sure our banks are profitable and safe. I have a ton of fixed rate loans, and you have a ton of variable rate loans. Perhaps I speculate that the interest rate is going to keep rising and will be above the 5% for the foreseeable future. I want to take that bet and get rid of some of my relatively less profitable fixed loans and get some of your variable rate loans. If I’m right and the market goes up, I make a higher return than I would have holding onto my fixed rate loans. If I’m wrong, I make less money than I would have. You on the other hand have a ton of variable rate loans. You’re worried that if the treasury rates drop, you’ll be in financial danger. So you want to diversify and hedge your portfolio to protect it from catastrophic loss. You’d like to trade some of your variable rate for some of my fixed rate loans so that even if the interest rates decline, you still have some income that is guaranteed at a certain rate that you can plan around.
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