Even as a teacher, you learn new things every day. Yesterday, a student asked me about OTC Derivatives Clearing and I had no idea what it was. So I researched and found the answer; it’s pretty interesting stuff so I thought I’d share it.
There are many different types of investments that can be used to increase your profits. However, there are certain investment opportunities that are more specified and have a more distinct purpose.An Interest Rate Swap is a form of OTC Clearing and is done through the use of a clearing house and are the exchange of cash flows between two parties. The swap rate that is exchanged is either fixed or floating. Why are interest rate swaps becoming so popular?
Basics of Interest Rate Swaps
It is important to understand that the principal amount of the payment is never exchanged between the two parties. The only exchange is in the interest rate, which is determined by the specified amount of the principal. The most common exchange of interest rate swaps involves the swap of a fixed rate for a floating rate. This means that instead of paying a fixed amount the rate will fluctuate based on the LIBOR.
Why Opt For Floating Over Fixed?
Exchanging a fixed interest rate for a floating interest rate may seem risky, but it is an investment opportunity that many firms, banks and corporations find appealing. Many parties that look to the Swap Rate find that predicting the LIBOR can be difficult, but it can also be a lucrative opportunity if you guess wisely. Trying to predict the LIBOR is contingent on many factors, but if you exchange a fixed rate for a floating rate when the LIBOR is most favourable you will have the ability to amass extensive savings and earn profits from the other party involved in the interest rate swap.
What About Fixed?
The advantage of swapping a floating rate for a fixed rate is all about risk management. If you want the ability to lessen the amount of risk that you face, it can be beneficial to swap interest rates with another party that has a fixed rate. Knowing your fixed rate gives many firms, companies and banks stability knowing that the rate will be consistent and will not fluctuate.
This type of investment opportunity is more specialized and not really ideal for individuals. It is often used by firms, companies and banks as a means of risk management or for calculated risk growth. The best part about these swaps is that they are overseen by a Clearing House and are completely guided by restrictions designed to protect both parties involved in the swap.