-31-
rate. The swap transfers to the counterparty the risk of a rise
in interest rates.16 Likewise, a financial manager may need to
increase or decrease the interest rate exposure of an entity’s
liabilities. The financial manager of a corporation, for
example, that has assets which are positively exposed to interest
rate risk (i.e., the value of the assets increases with interest
rates) may seek to match this exposure with liabilities that are
positively exposed to interest rate risk so as to create zero
exposure in the corporation’s net position.
ii. Prosper From Market Forecast
End users also use interest rate swaps to attempt to prosper
from their forecast of the movement in interest rates. For
example, a company that believes that interest rates will fall
may enter into an agreement under which it pays a floating
interest rate. In 1992 and 1993, for example, when interest
rates were at extremely low levels, many companies elected to
issue long-term debt at fixed rates and then enter into
shorter-term swap agreements under which the company paid a
floating rate. The company, in effect, converted the early years
of its financing from a fixed rate to a floating rate.
16 An entity that borrows at a floating rate and then buys a
fixed-for-floating swap of matching maturity and notional
principal is said to have synthetically created a fixed-rate
loan; i.e., the net of the payments on the floating-rate loan and
the swap mirror the payments on a fixed-rate loan.
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