Question

Explain how savings institutions could use interest rate swaps to reduce interest rate risk. Will Sis that use swaps perform better or worse than those that were unhedged during a period of declining interest rates? Explain.

Answer 1

Interest Rate Swap- Exchange of cash flow between two parties, wherein both the legs of the cash flows are based on interest rates (Fixed interest rate and Floating interest rate).

Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa to reduce or increasing exposure to fluctuations in interest rates or to obtain lower interest rate.

A savings institution can swap fixed payments in exchange for variable payments. If interest rates rise, variable inflow payments to the savings institution increase while the outflow payments remain fixed. Thus, the positive effect of the swap will offset the negative effect of higher interest rates on the saving institution cost of funds.

If interest rates declined, savings institutions that used swaps would perform worse than savings institutions that were unhedged. The positive effect on the extend could be offset by lower swap payments received during a period of declining interest rate.