What is an interest rate swap and what risks does it introduce?

• A. An agreement to exchange fixed and floating rate payments; risks include counterparty credit risk and basis risk.
• B. A debt instrument that pays fixed coupons.
• C. An agreement to speculate on currency movements.
• D. A loan with no risk.

Answer: (A)

Interest rate swaps involve exchanging cash flows on a notional amount, where one side pays a fixed rate and the other pays a floating rate that resets periodically. The notional isn’t exchanged, only the net payments. This setup lets parties hedge or speculate on interest-rate movements. The main risks are counterparty credit risk—what if the other party can’t meet its payments—and basis risk—the floating leg may not move in perfect sync with the exposure being hedged, leading to an imperfect hedge. Other risks can exist, but these are the primary ones people consider with plain-vanilla swaps. The other choices describe a fixed-rate bond, a currency speculation contract, or a loan with no risk, none of which capture the essence of an interest rate swap.