Interest rate swaps are derivative instruments commonly used by sophisticated investors to allow cash flows on interest-earning securities or loans to be exchanged. One of the most common examples of an interest rate swap is when two parties have different terms on loan agreements (e.g. fixed vs variable interest rates), and one party undertakes payments linked to short-term floating interest rates (such as LIBOR) in order to recieve fixed payments. The counterparty to this transaction then undertakes the fixed payments.
According to the Bank for International Settlements, the notional amounts outstanding for interest rate swaps were upwards of $364 trillion at the end of 2010, dwarfing the OTC markets for other types of derivative contracts. But how do these interest rate swaps work? Salman Khan of the Khan Academy explains interest rate swaps in the video below.
From the first video, you’ll understand:
- The agreements underlying interest rate swaps
- Why interest rate swaps contracts are written
- The meaning of notional value
From the second video, you’ll understand:
- How interest rate swap contracts can affect variable and fixed interest rates
- The effect of changes in LIBOR on these contracts
- How the cashflows work for interest rate swaps