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Word of the Week – swap rate
Find out what swap rates are, how they work, and why it matters for your mortgage.
A swap rate is the fixed interest rate that one party agrees to pay another in exchange for receiving a floating interest rate.
Essentially, it’s part of a financial agreement called a swap, where two parties exchange cash flows based on different interest rates. Swaps are typically used to manage interest rate risk or to speculate on changes in interest rates.
How does a swap work?
Imagine two companies. Company A has a loan with a fixed interest rate, but it thinks interest rates might go down in the future. Company B has a loan with a variable interest rate, but it wants the predictability of a fixed rate. They decide to enter into a swap agreement:
- Company A agrees to pay Company B a fixed interest rate.
- Company B agrees to pay Company A a variable interest rate based on an index like the London Interbank Offered Rate (LIBOR) or the new Sterling Overnight Index Average (SONIA).
They exchange these interest payments for a set period of time, without swapping the actual loans. This way, each company can achieve its desired interest rate exposure.
Why are swap rates important?
Swap rates are crucial because they help institutions manage their interest rate risk. For example, if a company has a lot of debt with a variable interest rate, it might worry about rates going up.
By entering into a swap where it pays a fixed rate and receives a variable rate, it can lock in a predictable payment, which makes budgeting easier.
Types of swaps
- Interest rate swaps: This is the most common type. One party pays a fixed rate, and the other pays a variable rate. It helps companies manage their exposure to interest rate fluctuations.
- Currency swaps: Here, parties exchange interest payments in different currencies. It helps manage exchange rate risk.
- Commodity swaps: These involve swapping cash flows related to commodity prices, such as oil or gas, and are used by companies to hedge against price changes in raw materials.
How are swap rates determined?
Swap rates are influenced by several factors, including:
- Market interest rates: The overall level of interest rates in the market affects swap rates. For example, if the Bank of England raises interest rates, swap rates will likely go up as well.
- Credit risk: The perceived credit risk of the parties involved can impact the swap rate. Higher risk means a higher rate.
- Supply and demand: The balance of supply and demand for swaps in the market can influence the rates. If more companies want fixed rates, the swap rate for paying fixed might rise.
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