An interest rate swap (IRS) is a financial contract that allows two parties to exchange interest payments on a loan. One party agrees to pay a fixed interest rate, while the other party agrees to pay a floating interest rate.
IRSs are typically used in securitisation to hedge against interest rate risk. Interest rate risk is the risk that the interest rate on a loan will change, which can affect the cash flow of the securitisation. By entering into an IRS, the securitisation issuer can lock in an interest rate, which can help to protect the securitisation from interest rate risk.
There are a number of applications for IRSs in securitisation. One application is to reduce the cost of borrowing for the originator. The originator of a securitisation transaction typically borrows money from investors to finance the purchase of the underlying assets. The interest payments that the originator makes to investors can be hedged by entering into an IRS.
Another application of IRSs in securitisation is to make securitisation transactions more attractive to investors. Investors in securitisation securities are typically looking for a predictable stream of income. By entering into an IRS, the securitisation issuer can lock in an interest rate, which can help to provide a predictable stream of income to investors.
Here are some other applications of IRSs in securitisation:
- To increase the liquidity of the securitisation market
- To provide a cushion against losses
IRSs can be a useful tool for both investors and originators. For investors, it can help to reduce the risk of default and to make securitisation transactions more attractive. For originators, it can help to reduce the cost of borrowing and to increase the liquidity of the securitisation market.