The best way to understand interest rate swaps is to try to empathize with your bank. (Stop laughing and pay attention!) Your bank borrows money short-term, mostly through six-month and one-year certificates of deposit, and lends long-term, mostly on 30-year fixed-rate mortgages. To fund the mortgage lending, the bank must continually replace that money by repeatedly writing CDs. To break even, your bank must lend money at more than 2 percentage points higher than its cost of borrowing, so to fund a 6 percent, 30-year mortgage, it must borrow the money at less than 4 percent. If interest rates rise substantially, the bank may find that it must pay 8 percent to attract CD money. This means it is losing 4 percentage points while interest rates are high. This is one way banks get into financial trouble.
The Other Side
At the same time your bank is lending 6 percent mortgage money, a corporation issues a 30-year corporate bond at a 4 percent interest rate. It prices its products according to inflation, so when interest rates rise, the prices of its products rise. It needs the tax write-off from the interest it pays on the corporate bond, but as it makes more money on its higher priced products, the 4 percent cost of funds provides little tax relief. It would rather borrow short-term like your bank.
Investment bankers arrange an interest rate swap between your bank and the corporation. Your bank agrees to pay the 4 percent interest on the corporate bond if the corporation agrees to pay the market interest rate required to attract CD deposits.
Your bank now has a fixed cost of funds of 4 percent for 30 years to fund its 6 percent 30-year mortgages. It doesn't make much money, but it doesn't lose money, either. The corporation now can write off on its taxes a cost of funds that rises as the price of its products rise.
Interest Rate Swap Marketplace
The above explanation is simplified, but it describes the basics of interest rate swaps. The size of most swap transactions exceeds $100 million, and many of these transactions take place each day. In 2008, the size of the interest rate swap market was $270 trillion, or roughly four times the size of the bond market.
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