You may have read about the banker who was recently convicted for fraudulently manipulating LIBOR, which is the interest rate at which the banks lend to each other. This manipulation of the rate may have had a profound impact on interest rate swaps and the underlying calculation of interest payable.
What is an Interest Rate Swap?
An interest rate swap is an agreement to exchange interest rate cash flows based on a specified notional value (usually linked to the value of an outstanding loan) from a variable rate (or floating rate) to a fixed rate, or vice versa.
Interest rate deals are technically known as liquid financial derivative instruments and form part of a businesses interest rate risk mitigation strategy.
Swapping a variable rate for a fixed rate allows a company to hedge against, and reduce exposure to, any rise in interest rates. However, the opposite is generally required for a business to benefit from a fall in interest rates.
Nevertheless, swapping a variable rate for a fixed rate gives a company greater certainty over the interest liability across the term of the loan.
The duration of interest rate swaps is usually linked to the duration of an underlying loan. A typical interest rate swap agreement may last from 25 to 40 years.