Introduction
Interest rate is the rate at which an organization, especially a financial institution acquires its profit. In the recent past, there have been several instances of interest rate swap among and between financial institutions and companies among others. Basically, an interest rate swap can be viewed to be an agreement between two organizations or companies to exchange cash flows of interest rates. Generally, this agreement must be based on a specific notional amount derived from either a floating rate or a fixed rate. Furthermore, it can be based on floating rate entirely. Interest rate swap between organizations in most cases is adopted due to two main reasons, which are speculating and hedging.
Examples of banks that apply interest rate swaps
Several banks mostly apply interest rate swaps. Banks legally agree with each other to embrace interest rate swaps to reduce risks and increase levels of profits, for instance, World Bank and Bank of England. These banks have established effective interest rate swaps to control inflation rates and financial crises in England. Generally, the interest rate swap between the World Bank and Bank of England is a major contributor to the financial status and strength of England. Moreover, there are other banks that also embrace the interest rate swaps among them, for instance, the Central Bank of Nigeria and its commercial banks, Dutch Bank and Bank of India among others.
Types of interest rate swaps
Interest rate swaps are commonly practiced between financial institutions, especially banks. However, there are different types of interest rate swaps that can be adopted by different financial institutions or banks. Choice of the type to adopt entirely depends on the agreement between the parties involved. Furthermore, it also depends on the intention for the swap agreement and the goals and objectives of the respective parties involved in the interest rate swap. Generally, there are several types of interest rate swap, but there are five types that are commonly practiced by financial institutions and banks globally (McCarthy 28). The commonly adopted interest rate swaps by banks include; fixed-for-fixed swap, fixed-for-float swap and float-for-float swap. Though there are three types, they are adopted depending on the intention and factor to be addressed by the financial institutions or banks involved, for instance, it can be aimed at different currencies or the same currency. Explanations of these types of interest rate swaps can be effectively highlighted through the use of financial institutions or banks in the economy, for instance, the World Bank and Bank of England. Generally, these two banks work closely hence adopt interest rate swaps in different ways. Basically, World Bank is the banker to several central banks in the globe. The World Bank is also in charge of ensuring global economic growth in different countries. However, the interest rate swap between these two banks is effective in demonstrating the different types of interest rate swaps considering the frequent transaction between the World Bank and Bank of England (McCarthy 34).
Importance of interest rate swap between banks
Interest rate swap is important and can be used to address several financial issues in the global economy. Basically, interest rate swap can be used by central banks to decrease or control rates of inflation and avoid risks of financial crisis among other financial factors. Generally, it is the central bank of a country that can effectively manipulate interest rate swaps and control inflation and financial crisis in the respective country. This is because the central bank is the only financial institution in a country that is concerned with well-being of the entire population and economic stability. On the other hand, most commercial banks are only interested in profit margins and may not effectively respond to financial crisis and inflation rates in case it increases their levels of profits (Silverstone and Sheetz 39).
Financial crisis
The financial crisis is an aspect that can greatly affect the economy of a country. However, the entire nation depends on the measures taken by the central bank to control it and restore and maintain confidence among the public. Financial crisis causes panic among the public due to its effects on the economy and cost of living among other factors that are determined or controlled financially. There are several measures that central banks may take to control financial crises and maintain confidence among the public. Though there are several measures that can be taken by central banks to control the financial crisis, there are only two measures that can effectively control the financial crisis. The measures that can be taken by central banks and effectively control financial crises are fiscal and monetary policies. These policies have different reactions to the financial crisis that can effectively control it since the financial crisis cannot be avoided. Though both measures can be taken to control the financial crisis, central banks can only implement monetary policy effectively. This is because central banks are in charge of the money supply in an economy (Hopwood, Young and Leiner 45).
The financial crisis is a financial condition that can be faced by any nation in the globe irrespective of their financial position in the global economic rank. Apart from fiscal and monetary policies that can be adopted in control of a financial crisis, effective manipulation of interest rates by banks, especially central banks can effectively assist in the control of the financial crisis, for instance, fixed-for-fixed interest rate swap for a different currency. There are different currencies used in the global economy (Manning 62). Furthermore, the value of currencies differs depending on the financial strength of respective nations in the globe. Adoption of the fixed-for-fixed interest rate swap on different currencies may enable a central bank to effectively address the issue of the financial crisis in the respective country where it serves (Hopwood, Young and Leiner 51).
Monetary policies
The central bank is the monetary authority in charge of the money supply in different countries. This policy is basically adopted by banks to ensure the stability of prices and reduce levels of unemployment. There are different monetary policies that can be adopted by a central bank to ensure it maintains confidence among the general public in case of a financial crisis. A central bank may decide to adopt an expansionary or contractionary monetary policy depending on the financial crisis prevailing in the respective country. These policies are also applied depending on the cause of the financial crisis. Basically, expansionary monetary policy is a policy that if adopted by central banks then it leads to an increase in the supply of money in the economy than usual. On the other hand, contractionary monetary policy is a policy that if adopted by the central bank then it leads to expansion of money supply in the economy slowly than usual. It can also lead to the shrinking of the money supply in the economy (Lenox 23). Moreover, these policies are used to counter different effects of the financial crisis. This is because a financial crisis may lead to different effects depending on its causes. Expansionary monetary policy is basically adapted to control recession and the rate of unemployment. It achieves this by reducing the rate of interest. On the other hand, contractionary monetary policy is adopted with an aim of controlling inflation in a country and its effects on the economy of the respective countries. There are different ways how central banks may execute these policies and ensure it maintains public confidence during the financial crisis (Hopwood, Young and Leiner 53).
Monetary policies are set with different targets. Generally, monetary policy is adopted depending on the prevailing effects of the financial crisis. These effects are also determined by the causes of the respective financial crisis. A policy may be adopted with an aim of combating different effects, for instance, inflation, mixed policy, gold standard, price level, fixed rate of exchange and the price level. There are several monetary policies that can be adopted by a central bank to assist in inflation and financial crisis control (Manning 35). However, these policies can be more effective if they are implemented alongside interest rate swaps, for instance, contractionary monetary policy adoption alongside a fixed-for-float interest rate swap for the same currency especially the currency of the respective country. This can effectively assist in the reduction of money supply in an economy leading to effective contractionary policy implementation. Furthermore, a fixed-for-float interest rate swap for the same currency can also assist in the implementation of expansionary monetary policy. Adoption of a fixed-for-fixed interest rate swap between banks especially commercial and central banks may lead to an increase in the number of supplies of money between the two banks especially in the commercial banks’ lending to the increased money supply in the respective economy. This is because it can effectively assist in the increment of the money supply in an economy (Lenox 49). Basically, the adoption of a fixed-for-fixed interest rate swap may enhance a decrease in rates of interest for commercial banks leading to an increase in the money supply in the respective economy. On the other hand, the adoption of a fixed-for-float interest rate may enhance an increase in the rate of interest for commercial banks leading to a decrease in money supply in the respective economy (Manning65).
Inflation targeting
The financial crisis may lead to inflation in a country. However, it is the duty of financial authority, for instance, the central bank to ensure that the inflation rate is contained and despite the public panic, their confidence is maintained. The central bank may contain inflation by reviewing its rate of interest. A central bank may increase the rate of interest for commercial banks to ensure a decrease in the supply of money in the economy because it will reduce commercial banks’ lending (Silverstone and Sheetz 44). On the other hand, a central bank may reduce interest rates on lending for commercial banks to ensure an increase in money supply in the economy. This is because a decrease in the rate of interest for commercial banks will ensure an increase in the supply of money in the economy hence stabilizing the economy. This approach was basically applied in New Zealand and has ever since been applied by several central banks in different countries, for instance, the Czech Republic, Brazil, India, South Africa and the United Kingdom among others. This policy has greatly assisted these countries to respond to the financial crisis in their respective countries through the adoption of the policy by their central banks (Manning 74).
Containing inflation is one of the main duties of a central bank in a country as the leading financer. Inflation can either originate in the respective country or can be imported into a country by a close business ally. Though there are several measures that can be taken by a central bank to contain inflation, interest rate swaps can also be used to effectively contain the situation. This is because in most cases inflation arises due to effects on rates of interest and currency value in the global economy. Adoption of the different types of interest rates can adequately assist a central bank in effectively responding to the inflation rate and containing or controlling it. There are different types of interest rate swaps that can be adopted by a central bank to effectively control the inflation rate depending on the cause of inflation, for instance, fixed-for-fixed interest rate swap, fixed-for-float interest rate swap and float-for-float interest rate swap (Manning 56). Furthermore, the swaps may be implied on the same currency or different currencies depending on the causes of inflation in the respective country or region (Hopwood, Young and Leiner 88).
Fixed-rate of exchange
The financial crisis may also be caused by the value of a currency in the global exchange market and the rate at which it exchanges foreign currencies. This policy may be adopted to ensure the stability of currency in relation to other currencies or a foreign currency. A central bank may decide to adopt the policy hence enforcing a dollarization policy. This policy encourages the use of foreign currency as the major medium of exchange. The policy can be adopted by a central bank in case it does not trust its local currency and strength or influence in the global market (Manning 72). This policy may greatly assist in the stabilization of prices and attracting investors. There are several central banks that have adopted the policy to ensure that the financial crisis is effectively responded to and its effects controlled. This policy has been adopted by most African states to control financial crises and maintain confidence among the public despite the panic (Lenox 93).
Fixed-rate of exchange can be used to minimize financial crisis and contain the rate of inflation in a country. However, the fixed rate of exchange sole implementation may not effectively assist in effective control of a financial crisis and the rate of inflation. Therefore, a central bank should also adopt fixed-for-fixed interest rates with foreign central banks or other foreign financial institutions. This can effectively assist a central bank to ensure it maintains a fixed rate of exchange between the currency of the respective country and foreign currencies (Manning 62). Furthermore, a fixed-for-fixed interest rate swap can also enable a central bank to control financial crises effectively and adequately. Therefore, to adequately and effectively control financial crisis and rate of inflation, a central bank should consider the implementation of a fixed rate of exchange alongside a fixed-for-fixed interest rate swap to ensure the establishment of a fixed rate of exchange between its currency and foreign currencies (McCarthy 74).
Gold standard
This is also one of the most common policies that are adopted by most central banks. This is due to the response of the policy to the financial crisis. This policy adopts the principle of measuring the local currency in gold bar units. This measure is basically stabilized by a government promise of selling and buying gold at fixed prices. Though this policy is effective and efficiently responds to the financial crisis, it is no longer in use by central banks. This policy was mainly used in the mid-nineteenth century. This policy was mainly used by most central banks in the past because it was the simplest to understand and implement. It was also transparent hence could easily be explained to economic stakeholders for better understanding. This policy induces deflation, which might lengthen the time spent by an economy in responding to the recession and or financial crisis (Silverstone and Sheetz 53). Therefore, though the policy is not presently used or applied by central banks, it was greatly used by most central banks in the past to effectively respond to the financial crisis and maintain confidence among the public despite the panic during the financial crisis. Though this policy is not frequently adopted by central banks currently, it could be effectively implemented alongside interest rate swaps to ensure an effective and adequate response to the financial crisis (Lenox 57).
Basically, this policy could be effectively implemented alongside float-for-float interest rate swap. This is because a float-for-float interest rate swap could enhance the effective measure of a currency on gold bar units. Therefore, considering the nature of financial crises and inflation in different countries, and different responses that may be adopted to assist in the control of inflation rate and minimization of financial crises, interest rate swaps should be implemented alongside these policies that may be implemented in control of both financial crises and inflation. This is because these policies can be effectively and adequately implemented if adopted and implied alongside these interest rate swap types (Manning78).
Impact of interest rate swap
There are different businesses in the global economy. However, businesses are broadly divided into profit and non-profit organizations. Generally, all organizations require funds and finances to run their activities and achieve their goals and objectives. Though non-profit organizations are not after profit maximization, they must effectively manage their finances and funds. Profit-oriented organizations especially financial institutions and companies struggle to gain competitive advantage, increase their market share and profit levels in the respective industry (Mouse 19). Basically, an interest rate swap is used by most profit-oriented organizations. There are several reasons that may compel an organization to adopt interest rate swaps, for instance, risk reduction (Silverstone and Sheetz 64).
Risk reduction
There are several uncertainties involved in organizations. This is because an organization is formed with a possibility of either failing or prospering, loss or profit, and continued operation of closure of operation. There are two environments in business operation, for instance, external and internal business environments. Organizations and companies have a direct influence on the internal business environment factors, but not the external business environment factors. However, these factors affect the operations of organizations and companies irrespective of the size and nature of business the organizations or companies engage in (Mouse 29). Generally, external business factors pose threat to the existence of companies and organizations. Organizations must establish an effective risk management plan to ensure reduction in risks involved in the operation, which might affect profit generation and effective management of finances within a company or firm. There are several risk reduction plans that can be adopted by the management of a bank, company or organization, for instance, interest rate swap (Silverstone and Sheetz 74).
Organizations or companies can effectively and adequately use the interest rate swap to reduce risks involved in operations that can affect the profit levels of the respective organization. Basically, an interest rate swap is a rate at which organizations or banks may agree to exchange cash flows and interest rates. These rates are basically on a float or fixed rates depending on the agreement between the parties involved. Application of interest rate swap by organization may enable an organization to experience a reduced cash flow (Mouse 42). Generally, the profit levels of an organization depend on the cash flow of the respective organization or company. Incoming cash should not be lower than the outcoming funds from the organization that is expenditure should not be greater than incomes because it might affect the levels of income of the respective organization. Increased expenditure may increase risks in the respective organization. Decreased cash flow in an organization can effectively assist the management to reduce risks involved in the management of finances leading to increased revenue. Therefore, the adoption of the interest rates between companies or banks may enable the respective organizations to reduce risks through a decreased cash flow in the respective organizations (Silverstone and Sheetz 74).
Profit increase
Interest rate swaps are based on a float or fixed policies. Adoption of the most appropriate policy to adopt depends on the agreement between the parties and location. Basically, organizations or banks within the same country may most likely adopt the same currency on either float-for-float or fixed-for-fixed because they operate with the same currency. On the other hand, companies or banks from different countries, especially those in trade ties or relationships can also adopt fixed-for-fixed, fixed-for-float or float-for-float but based on different currencies. This is because currencies by the parties involved might be different in case, they don’t have a common trading currency (Silverstone and Sheetz 81).
Adoption of interest rate swaps by companies or banks may assist the respective organizations or banks to increase their levels of profit. Basically, an interest rate swap may assist a company or a bank to reduce its cash flow leading to increased profit generation. However, the adoption of the best type of interest rate swap may also enhance an increase in profit. This is because there are different types of interest rate swaps and the adoption of implementation of each type depends on the needs and agreement between the parties involved (Mouse 56). Furthermore, different types of interest rate swaps are applicable to different situations in organizations and banks. Additionally, their effectiveness also varies. Therefore, the impact of an interest rate swap depends on the chosen type and agreement between the parties involved. Furthermore, effective implementation of the respective types of interest rate swap may enhance the profit levels of the respective organizations and increase their market share in the long run (Silverstone and Sheetz 84).
Conclusion
Interest rate swap is a strategic management plan that can be adopted by banks, companies and other financial institutions among others. It is based on either float or fixed policy. Generally, this strategy is in most cases applied by banks and financial institutions. There are different types of interest rate swaps. The interest rate swaps that are commonly used by organizations and companies are fixed-for-fixed interest rate swap, float-for-float interest rate swap and float-for-fixed interest rate swap.
Furthermore, these policies are either based on the same currency or different currencies depending on the currency used for trade or business by the respective companies or parties involved in the interest rate swap. Though interest rate swap can be used by different banks and companies, it is most appropriate for central banks. This is because there are several benefits that the application of interest rate swap by central banks may bring to an economy, for instance, inflation rate control. Additionally, interest rate swaps can be used by central banks to control and avoid a financial crisis in the respective country where the policies are applied.
Interest rate swap is effective and appropriate for use by organizations. This is because there are several corporate advantages that can be derived from the application of these policies, for instance, the reduction of risks. Businesses are formed with a possibility of failure or success. However, interest rate swap can be used by organizations are a strategic management plan hence assisting in the reduction of risks involved in the operation of the respective business. Furthermore, it can be used to ensure an increase in the profit levels of an organization or bank. Basically, an interest rate swap can be used by an organization to control the cash flow of the organization. Control of cash flow by an organization may enable the respective organization to effectively manage its finances and funds leading to reduced expenditure and track of finances leading to increased profits and market share by the respective organization or bank in the industry where it operates. Therefore, effective application of an interest rate swap and choice of the best type by an organization or bank may positively impact an organization and enable it to reduce risks and increase profit levels in the respective industry where it operates.
Works Cited
Hopwood, William, Young, George, and Leiner, Jay. Interest Rate swap. McGraw-Hill Companies, Inc, 2011. Print.
Lenox, Marcel. Interest Rate Swap and Central Banks. New York: Springer, 2009. Print.
Manning, George. Importance of interest rate swap. Chicago: CRC Press, 2010. Print.
McCarthy, David. Types of Interest rate swaps. Cambridge; Cambridge UP, 2011. Print.
Mouse, Mika. Impacts of Interest rate swap. Indiana: Pearson Education, 2010. Print.
Silverstone, Howard and Sheetz, Michael. Impacts of Interest rate swaps. New York: John Wiley and Sons, 2011. Print.