Question

Chelsea Finance Company receives fixed inflow payments from its provision of fixed rate loans. Its outflow payments are floating-rates.
a) Describe the interest rate risk faced by Chelsea. How can Chelsea use swap to hedge against the interest rate risk?
b) If Chelsea expects interest rate to fall, what feature can it add to the swap to protect itself from losing too much?
c) What are the main risks associated with swaps?

Answer 1

a) Rate of Interest for inflows are fixed whereas rate of interest for outflows payments are floating rates.There is a interset rate risk faced by the company if there is rise in the interest rate as it will increase our outflow.By entering interest rate swaps it will allow company to exchange interset rate payments on the agreed amount for the agreed period of time which will hedge against adverse interest rate movements.

b) If Chelsea expects Interest rate to fall then chelsa should enter floating rate swaps which will protect from adverse interest rate movements.

c) They main risks associated with swaps are interest rate risk and credit risk.

Inerest rate risk is such suppose you(receiver) enter a fixed rate swap and there is rise in interset rate in such case you will loose interst on such increased rate of interest and vice versa.

Credit risk is risk of default to make payment by either of the party entering swap contract.This risks can be mitigated some how but it can't be evaded at all.