Accounting for Investments, Volume 2: Fixed Income Securities and Interest Rate Derivatives—A Practitioner's Guide

BENEFITS OF INTEREST RATE DERIVATIVES

Reasons for using interest rate swaps

Interest rate swaps are used by a wide range of commercial banks, investment banks, non-financial operating companies, insurance companies, mortgage companies, investment vehicles and trusts, government agencies and sovereign states for one or more of the following reasons:

• To hedge interest rate exposure;
• To take speculative positions in relation to future movements in interest rates;
• To lower the cost of funding;
• To create new types of investment assets not otherwise available;
• To implement the overall asset-liability management strategies.

To hedge interest rate exposure

An entity that provides fixed rate loans is exposed to pre-payment risk when faced with falling interest rates. The borrowers may prefer to close the existing mortgage and re-finance the same at a lower rate. The entity can protect against this risk by entering into an interest rate swap by receiving fixed and paying floating interest. Depending upon the risk management policy of the entity, the entity can opt to convert a portion of their lending portfolio from fixed rate to floating rate by entering into appropriate interest rate swap contracts.

To take speculative positions in relation to future movements in interest rates

The entity may want to take a speculative position on short-term interest rates and lower its cost of borrowing even further if in its judgment the level of future interest rates is expected to fall. There are ...