21. An interest rate swap

An interest rate swap (IRS) is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. Interest rate swaps are commonly used for both hedging and speculating.

Why companies may want to engage in interest rate swaps:

1. Commercial motivations. Some companies are in businesses with specific financing requirements, and interest rate swaps can help managers meet their goals. Two common types of businesses that benefit from interest rate swaps are:

• Banks, which need to have their revenue streams match their liabilities. For example, if a bank is paying a floating rate on its liabilities but receives a fixed payment on the loans it paid out, it may face significant risks if the floating rate liabilities increase significantly. As a result, the bank may choose to hedge against this risk by swapping the fixed payments it receives from their loans for a floating rate payment that is higher than the floating rate payment it needs to pay out. Effectively, this bank will have guaranteed that its revenue will be greater than it expenses and therefore will not find itself in a cash flow crunch.

• Hedge funds, which rely on speculation and can cut some risk without losing too much potential reward. More specifically, a speculative hedge fund with an expertise in forecasting future interest rates may be able to make huge profits by engaging in high-volume, high-rate swaps.

22. The characteristics of the Eurodollar market

Eurodollar time deposits are U.S. dollars on deposit outside the United States, either with a foreign bank or a subsidiary of a U.S. bank. Eurodollars have two basic characteristics: they are short-term obligations to pay dollars and they are obligations of banking offices located outside the U.S. In principle, there is no hard and fast line between Eurodollars and other dollar-denominated claims. The interest paid for these dollar deposits generally is higher than for funds deposited in U.S. banks because the foreign banks are riskier - they will not be supported or nationalized by the U.S. government upon default. Furthermore, they may pay higher rates of interest because they are not regulated by the U.S. government. They are backed by the full faith and credit of the local domestic bank and are issued by its offshore branch. Eurodollar time deposits are designed for corporate, commercial, institutional and high-net-worth investors who want a short-term, high-yield money market investment. Foreign commercial banks such as the Bank of London and South America, Ltd., merchant banks such as Morgan Grenfell and Co., Ltd., and many of the foreign branches of U.S. commercial banks are engaged in Eurodollar business. Funds placed with these institutions may be owned by anyone- U.S. or foreign residents or citizens, individuals or corporations or governments.