[eli5] Interest Rate Swaps?

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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?

Thank you!

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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.

There is no real “lender” or “borrower” in terms of an interest rate swap, just a payer (of the fixed rate) or receiver (of the fixed rate). However I’m assuming you mean the dealer, i.e. you as a client would go to a dealer to enter into an interest rate swap agreement. More on this near the end.

A vanilla interest rate swap is simply two sets of regular interest cash flows on a principal sum of money for a fixed amount of time – one set is floating rate, based e.g. on LIBOR (these days LIBOR replacements like SOFR compounding, but we can ignore that), the second set is fixed rate.
The important thing is that as of the time of the swap, these cash flows, when discounted to today, taking into account future expectations of interest rates, sum up to zero. I.e. the fixed cash flows are equal in value to the expected variable-rate cash flows. This is fair value.

Now, once the agreement is entered into, the payer of the fixed rate will make money if the current market interest rates increase, because they’ll be paying a series of fixed payments that will sum up to less than they would have if they were paying variable rates. Conversely, the receiver of the fixed rate will lose money. The opposite is true if market interest rates drop – the payer loses, the receiver wins.

Back to the original question – typically dealers do not keep these exposures to rates like this. Instead, they try to make money on volume, in a similar way to Travelex or other travel money currency exchange places – they show bid/offer prices, I.e. the rate they are willing to pay fixed (their bid) and the rate they are willing to receive fixed (their offer). The bid will be lower than the fair value, the offer will be higher than the fair value.

They then go out to market themselves to hedge their exposure to the swap, possibly by entering into an interest rate swap of their own and make the spread between the two products.

Example:

You ask for a two year swap, let’s say it’s 5% fair value due to current interest rates, but the dealer quotes you 4%/6% bid offer. You want to pay fixed, so you agree to pay 6%. The dealer then goes by themselves to another dealer, who quotes them 4.5%/5.5% (tighter market because they have better credit than you). They then accept to pay that dealer 5.5%, making them a net total of a safe 0.5%, not exposed to interest rate moves*.

* not entirely true, but beyond the scope of this