What Are Interest Rate Swaps?
Interest Rate Hedging Products (IRHPs or Interest Rate Swaps) are products which are used either to fix, or to limit fluctuations in, interest rates. These were sold to small and medium-sized businesses as protection from rising interest rates when taking out loans.
Types of interest rate hedging products
There are four main types of interest rate hedging products which were sold to businesses:
- A swap is a contract whereby if the interest rate of the underlying loan rises above an agreed point, the bank makes a payment to the customer. If the interest rate falls below the agreed point, the customer makes a payment to the bank. The effect of these payments is intended to offset the difference in interest rate, and keep the customer’s payments stable.
- A cap is a contract whereby the customer pays a premium in order to effectively stop their payments rising above a certain amount. If interest rates rise above the agreed level, the customer receives a payment from the bank. If interest rates fall below the agreed level, the customer does not receive a payment.
- A simple collar is a contract whereby if the interest rate rises above an agreed point (the ceiling), the bank will make a payment to the customer to offset this. If interest rates fall below a different agreed point (the floor), the customer makes a payment to the bank. The effect is to restrict fluctuation in the payments to within these pre-agreed limits.
- A structured collar differs from a simple collar in that if the interest rate falls below the agreed floor, the customer can end up paying a higher interest rate to the bank.