In addition to forwards, futures, and options, financial institutions use one other important financial derivative to manage risk. Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments (not assets) it owns for another set of payments owned by another party. There are two basic kinds of swaps. Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency. Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency.

Interest-Rate Swap Contracts

Interest-rate swaps are an important tool for managing interest-rate risk, and they first appeared in the United States in 1982, when, as we have seen, there was an increase in the demand for financial instruments that could be used to reduce interest-rate risk. The most common type of interest-rate swap (called the plain vanilla swap) specifies (1) the interest rate on the payments that are being exchanged; (2) the type of interest payments (variable or fixed-rate); (3) the amount of notional principal, which is the amount on which the interest is being paid; and (4) the time period over which the exchanges continue to be made. There are many other more complicated versions of swaps, including forward swaps and swap options (called swaptions), but here we will look only at the plain vanilla swap. Figure 2 illustrates an interest-rate swap between the Midwest Savings Bank and the Friendly Finance Company. Midwest Savings agrees to pay Friendly Finance a fixed rate of 5% on $1 million of notional principal for the next ten years, and Friendly Finance agrees to pay Midwest Savings the one-year Treasury bill rate plus 1% on $1 million of notional principal for the same period. Thus, as shown in Figure 2, every year the Midwest Savings Bank would be paying the Friendly Finance Company 5% on $1 million, while Friendly Finance would be paying Midwest Savings the one-year T-bill rate plus 1% on $1 million.

Interest-Rate Swap Payments

FIGURE 2. Interest-Rate Swap Payments

In this swap arrangement with a notional principal of $1 million and a term of ten years, the Midwest Savings Bank pays a fixed rate of 5% x $1 million to the Friendly Finance Company, which in turn agrees to pay the one-year Treasury bill rate plus 1% x $1 million to the Midwest Savings Bank.

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