Separation of Interest Rate Risk and Credit Risk

Banks are averse to making long-term loans at fixed rates of interest because of the interest rate risk. Hence, they feel more secure with the floating-rate loan. With a swap, the borrower can convert the floating-rate loan to fixed-rate and avoid the interest rate risk. The swap allows the separation of interest rate risk from credit risk. The bond market carries interest rate risk and the bank carries the credit risk. In pure interest rate swaps, there is no exchange of notional or actual principal. If the times of reciprocal interest payments coincide, only the net difference is paid.

Interest rate risk represents the vulnerability of a bond to movements in prevailing interest rates. Bonds with more interest rate risk tend to perform well as interest rates fall, but they start to underperform as interest rates begin rising.

Credit risk, on the other hand, signifies a bond’s sensitivity to default, or the chance that a portion of the principal and interest will not be paid back to investors. Individual bonds with high credit risk do well as their underlying financial strength improves, but weaken when their finances deteriorate. Entire asset classes can also have high credit risk; these do better when the economy is strengthening and underperform when it slows down.

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