What Is An Interest Rate Swap Anyway?

An investment officer at a community bank recently told me that he kept hearing and reading about “swap spreads” and “the swaps curve” and really didn’t know exactly what those things were. He was right to ask since a great deal of financial analysis these days relies on the swaps market as a source of information about expectations for interest rates, credit risk and bond market behavior. I was quick to explain that interest rate swaps are primarily the domain of money center banks, super-regionals, and large financial institutions. It really doesn’t make sense for small community banks to engage in interest rate swaps for a number of reasons including minimum size requirements, high transaction costs, and burdensome accounting issues. Nonetheless, some basic understanding of the swaps market is worthwhile.