Differences Between Interest Rate Swaps and Credit Default Swap

Differences between Interest Rate Swaps & Credit Default Swaps
Interest rate and credit default swaps are speculative contracts between organizations.
Interest rate swaps and credit default swaps are sophisticated financial management techniques. Although their
names are similar, these investment tools have little in common. Differences exist in the features and purpose of
interest rate and credit default swaps, as well as the types of organizations that engage in each. Both instruments
carry a different set of inherent risks, as well.
Features
In an interest rate swap, companies agree to trade interest rate provisions by allowing each other access to each
other’s' credit arrangements. Companies that wish to trade a fixed interest rate for a variable interest rate, or vice
versa, engage in interest rate swaps with other companies to take advantage of the favorable terms offered to their
swap partner.
Credit default swaps are essentially a form of default-risk insurance. Companies holding fixed-income securities,
such as municipal bonds, purchase credit default swaps from banks and other financial institutions. The swap
purchaser pays a regular premium to the seller in return for a guarantee of payment in the event the fixed asset turns
sour.
Purpose
Interest rate swaps are performed to lower the cost of credit by taking advantage of another company's credit lines.
Each interest rate swap must involve two parties, each of whom wishes to utilize the interest rates enjoyed by the
other. If one company has access to fixed rate credit, for example, and believes that a floating rate loan will be more
profitable in the near future, they may trade their fixed rate credit to a company who has access to floating rate credit
and believes that a fixed rate will be more profitable.
Credit default swaps serve two purposes. The most basic purpose is as a form of insurance, as mentioned, to protect
against the risk of default on fixed-income securities. The seller of a credit default swap counts on the seller of the
security to make good on his payments, allowing the swap seller to collect premiums without incurring any financial
obligations.
Investors also use credit default swaps as a trading and profit-generating technique. Because these instruments are
traded over the counter, there are very few restrictions on trade. Investors can purchase credit default swaps on debt
that someone else holds, betting that the asset will fall into default. Swaps can also be traded among investors to
reap marginal profits.
Risks
Interest rate and credit default swaps present unique risks to both parties. Interest rate swaps are a bit safer; parties to
an interest rate swap risk getting locked into a less favorable interest rate than they had hoped if their own interest
rate turns out to be more beneficial. Credit default swaps carry more systemic risk, making them a much more
sophisticated investment.
If economy-wide default becomes a problem, swap issuers may find themselves unable to meet all of their swap
obligations, damaging investment portfolios and creating ripple effects throughout the economy. If default swaps are
traded too prolifically, swap holders may find it challenging to ascertain the original swap seller.
What Are the Functions of an Intermediary in an Interest Rate Swap?
Intermediaries facilitate swap deals.
Interest rate swaps provide counter-parties with the opportunity to exchange fixed-rate and floating-rate cash flows.
Large financial institutions, such as banks, commodity market participants and hedge funds, dominate the market for
interest rate swaps. However, small businesses can use interest rate swaps to reduce exposure to interest rates on
liabilities. The major role of swap intermediaries is to broker deals, but they can perform a number of other valuable
functions.
Setting Up a Deal
One party to an interest rate swap receives a fixed cash flow and wants to exchange it for a flow based on current
interest rates. The other party has the opposite goal -- exchanging floating for fixed. A swap intermediary, also
known as a swap bank, is in the business of matching potential swap counter-parties and helping to negotiate a deal
between them. Frequently, the swap counter-parties are unknown to each other even after the deal is consummated,
because each party deals only with the swap intermediary. The intermediary takes a fee or a percentage of the swap
cash flows, depending on the contract details.
Swappers Anonymous
Swap counter-parties often value anonymity because of competitive considerations. To put it bluntly, a counter-
party might not want its competitors to know how it’s conducting business, offsetting its risks and financing its
capital. All of these tidbits of information could, if revealed to a competitor or other market participants, have an
adverse effect on the counter-party. For example, a hedge fund might form an opinion on prices in a particular
market and engage in large swaps to benefit from the opinion. The hedge fund would not want to tip off others,
because this might affect prices in the market covered by the swap.
Reducing Credit Risk

A swap intermediary often administers all of a swap’s cash flows. It collects and forwards periodic payments
between counter-parties, thereby maintaining anonymity. Frequently, the intermediary also performs credit services,
including assessing the creditworthiness of the counter-parties and even guaranteeing timely payment of cash flow.
For a fee, the intermediary agrees to make good on all or part of a cash payment if one of the counter-parties defaults
on its obligations.
Lending Expertise and Access

Swaps can become very complicated. A trusted intermediary can be a valued asset to swap counter-party because of
all the specialized knowledge the intermediary brings. This can give the intermediary a strong negotiation position
on your behalf, resulting in the most favorable deal with the least risk. A well-established swap intermediary also
gives a new counter-party access to large potential counter-parties in a particular market, access that would be hard
to generate otherwise.

Differences Between Interest Rate Swaps and Credit Default Swap

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Differences Between Interest Rate Swaps and Credit Default Swap

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Differences between Interest Rate Swaps & Credit Default Swaps

What Are the Functions of an Intermediary in an Interest Rate Swap?

Intermediaries facilitate swap deals.

Reducing Credit Risk

Lending Expertise and Access

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