How Interest Rate Swaps Work

The phrase ‘interest rate swaps’ is often used as shorthand for several products used by firms with outstanding bank loans to cut their exposure to rising interest rates.

Different types include swaps, collars and structured collars.

A customer who purchases a swap buys a contract that pays them money if interest rates go up from a fixed point. This will offset the higher costs on their loan. Conversely, if rates go down, they will be required to pay money to the bank, but that will be offset by the lower interest rate on their loan. The overall effect should be effectively to fix the interest rate for the customer.

However, it was never envisaged that interest rates would fall to the historic lows seen in the wake of the banking crisis, and this has caused buyers to face unexpected costs.

The other products causing most problems are structured collars. A collar, as its name suggests, is a product that limits the range within which the interest rate on a loan can move.

But structured collars add complex terms and conditions that can mean if rates fall to an extreme low as they did in 2008 and after, the customers actually face higher costs.

SOURCE: http://www.thisismoney.co.uk/money/news/article-2278697/FSA-tells-banks-compensate-firms-rate-swap-mis-selling.html?ito=feeds-newsxml