An interest rate swap is a deal between two investors. One has his money in a product paying a fixed rate of interest, such as a government bond; the other in a variable rate instrument that pays out in line with short-term interest rates. To hedge against future interest rate movements, the investors may agree to ‘swap’ the interest payments they get. For example, banks tend to have liabilities, such as deposits, that pay out at variable rates, but assets that receive a fixed return. That makes them vulnerable to rising short-term rates and so they may want to shield themselves by swapping their fixed interest for variable income. ‘Swaps’ are closely watched as an indicator of where markets think interest rates are heading.
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