Video: Interest Rate Swaps

In this lesson, Nick Palazzolo, CPA, demystifies the concept of interest rate swaps with approachable real-world examples. He illustrates how two parties might enter into a swap agreement to manage their concerns about potential fluctuations in interest rates, using the example of neighbors with fixed and adjustable-rate mortgages. Nick clarifies the implications of such an agreement, including how one party might benefit or lose depending on the actual movement of interest rates. By breaking down the function and impact of interest rate swaps, Nick ensures that you grasp this financial instrument and why it's relevant not just for the exam, but also in understanding broader economic events.

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Video Transcript

Instructor: Nick Palazzolo

Nick Palazzolo is head instructor of ExamPrep.ai CPA Review. Nick's teaching style is engaging & upbeat, combining practical Big 4 tax & assurance expertise with years of 1-on-1 coaching. His lessons are concise and emphasize what you need to know to pass. Whether you're a recent grad or working full-time, we’re confident you can conquer your CPA exams with Nick’s review.

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Now, interest rate swaps. Again, like you're not going to need to know any of these things you're really going to probably get direct questions on. But understanding the concepts is important for this test as well as BEC because you'll see them in questions and it could easily throw you off if you don't know generally what it's talking about. Now, I'll say generally you have fixed rate and adjustable rate. Now you could be, let's say you and your neighbor live next to each other, you and your neighbor, your best friends, you live in the good life and you signed an adjustable rate mortgage which currently is at 2%.

Now, I'm not going to go into the reasons why interest rates would go up or down, but they do. And your neighbor signed a fixed rate mortgage at 5%. So you have an adjustable rate, meaning your rate can go up or down. The fixed rate, no matter what happens in the economy of the world, that fixed rate is going to be at 5%. Now, let's say you get fearful and you say, I think interest rates are going to go up to something like 15%.

So yes, you initially got a much better rate than your neighbor, but you're concerned. So you go to your neighbor and say, hey, what do you think interest rates are going to do? Your neighbor says, oh, I think they're going to stay pretty low, they're not going to go anywhere and we are good the way it is because you have opposing viewpoints. You both might enter into a contract that says, okay, we just basically swap interest rates. So now you get the fixed rate.

So you are locked in at 5%. Your neighbor gets the adjustable at 2%. Your

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