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b. End Users’ Uses of Interest Rate Swaps
i. Combat Interest Rate Changes
End users commonly use interest rate swaps to hedge
(minimize) their risk of adverse changes in interest rates.
Interest rate risk is the potential fluctuation in the value of a
financial instrument due to a change in the level of interest
rates. Whereas the market values of fixed-rate loans are exposed
to significant interest rate risk, the market values of
floating-rate loans are not. A fall (or rise) in interest rates
causes the market value of a fixed-rate loan to increase (or
decrease). The fall (or rise) in interest rates leaves the
market value of a floating-rate loan unchanged; the interest
payments on the floating-rate loan fall (or rise) together with
interest rates.
Managing interest rate risk is an important function of
financial managers in entities such as corporations and financial
institutions, and an interest rate swap is a tool with which
financial managers may readily change their exposure to interest
rate fluctuations. Through a swap, an institution may change the
nature of its liabilities from fixed-rate liabilities to
floating-rate liabilities, or vice versa. A company liable on
debt paying a floating interest rate, for example, may guard
against a rise in interest rates by entering into a swap under
which it pays a fixed rate of interest and receives a floating
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