Advantages of Interest-Rate Swaps
To eliminate interest-rate risk, both the Midwest Savings Bank and the Friendly Finance Company could have rearranged their balance sheets by converting fixed-rate assets into rate-sensitive assets, and vice versa, instead of engaging in an interest-rate swap. However, this strategy would have been costly for both financial institutions for several reasons. The first is that financial institutions incur substantial transaction costs when they rearrange their balance sheets. Second, different financial institutions have informational advantages in making loans to certain customers who may prefer certain maturities. Thus adjusting the balance sheet to eliminate interest-rate risk might result in a loss of these informational advantages, which the financial institution is unwilling to give up. Interest-rate swaps solve these problems for financial institutions, because, in effect, they allow the institutions to convert fixed-rate assets into rate-sensitive assets without affecting the balance sheet. Large transaction costs are avoided, and the financial institutions can continue to make loans where they have an informational advantage.
We have seen that financial institutions can also hedge interest-rate risk with other financial derivatives such as futures contracts and futures options. Interest-rate swaps have one big advantage over hedging with these other derivatives: They can be written for very long horizons, sometimes as long as twenty years, whereas financial futures and futures options typically have much shorter horizons, not much more than a year. If a financial institution needs to hedge interest-rate risk for a long horizon, financial futures and option markets may not do it much good. Instead, it can turn to the swap market.