Hedging Using Interest Rate Swaps

In this lesson, we will look at a few examples of how corporations and financial institutions use interest rate swaps.

GAP Management

This example represents a financial institution, a bank, that is “lengthening the maturity,” “fixing” the interest rate, on its funding base in order to better match the funding costs with the fixed rate yield from its assets, say loans or investments.

In the example, the effective fixed rate debt cost is now 11 + 1/8%.

Liability Management

In this example, a synthetic floating rate note, i.e., floating rate debt, could be created by converting a long-term liability (for example, term deposits of a bank or fixed rate debt of a corporation or bank) to a floating rate.

The issuer in this example had borrowed term funds at a 13% fixed rate and transformed them to an effective floating rate cost of treasuries plus 1.

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