An entity that does not have access to a fixed-rate loan can borrow at a variable rate and enter into a swap to obtain a fixed rate. The variable rate term, resilience and payment dates of the loan are reflected and cleared on the swap. The fixed-rate portion of the swap becomes the entity`s interest rate. The bond maturity is a linear approximation of the change in the price of the loan for a certain change in yield. Investors use duration and convexity to predict how the price of a loan will react to changes in interest rates. The customizable payment is linked to libor, it is the interest rate that banks calculate each other for short-term loans. Libor is based on the Fed Funds rate. The beneficiary can have a loan with low interest rates, barely higher than the Libor. But it may favor the predictability of fixed payments, even if they are a little higher.
Fixed rates allow the beneficiary to forecast his income more accurately. This elimination of risk will often boost stock prices. The stability of the cash flow allows the company to have a small reserve of emergency cash that it can plough. For example, a company thinks that long-term interest rates are likely to rise. It can hedge its exposure to changes in interest rates by exchanging its variable rate credit payments for fixed income payments. This is a good example of how counterparties can use an interest rate swap for mortgage interest. Swaps are useful if one company wants to get a variable rate payment, while the other wants to limit future risk by receiving a fixed-rate payment instead. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires certain interest rate swaps to be settled.
To this end, the Commodity Futures Trading Commission registers companies called “derivative clearing houses”. Note: Interest rate swaps and bond futures are examples of derivatives. While bond futures derive their value from bonds, interest rate swaps derive their value from cash flows traded. ABC Company and XYZ Company enter into a one-year interest rate swap with a face value of $1 million. . . .