A:

An airbag swap is an interest rate swap designed to provide a cushion against rising interest rates. The airbag swap originally was designed for insurance companies because their balance sheets are especially sensitive to interest rate movements and the premature redemptions associated with rising rates. However, the use of airbag swaps has expanded to a variety of industries seeking to offset depreciation in their fixed-income portfolios due to adverse interest rate fluctuations.

Typically, an airbag swap consists of a pay-fixed, receive-floating structure with a rate tied to a constant maturity swap (CMS). Like all derivatives, a company engaging in an airbag swap pays for the privilege of hedging against rising interest rates.

For example, suppose a company's fixed-income portfolio yields 10%, while CMS floating rates yield 9%. Additionally, said company expects interest rates to rise in coming years. In order to hedge against this possibility, the company would enter into an airbag swap with a counterparty and pay the counterparty 10%. In turn, the company would receive the 9% interest rate. Should interest rates rise, the interest rate the company receives also would rise. In case you're wondering why a company would enter into this type of swap agreement knowing that the rate they are paid could decrease, swaps increasingly include both ceilings and floors to protect both parties from highly adverse interest rate fluctuations.

For more on this topic, read An Introduction to Swaps.

This question was answered by Justin Bynum.

RELATED FAQS
  1. Can individual investors profit from interest rate swaps?

    Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >>
  2. What is an absolute rate?

    An absolute rate is easy to understand once you know the basics of an interest rate swap. An absolute rate is the fixed rate ... Read Answer >>
  3. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
  4. Do interest rate swaps trade on the open market?

    Learn how interest rate swaps are traded on the OTC and interbank markets, and how these swaps can be used to arbitrage different ... Read Answer >>
  5. Can bond traders trade on interest rate swaps?

    Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>
  6. What are some risks a company takes when entering a currency swap?

    Read about the risks associated with performing a currency swap, including counterparty credit risk in the event that one ... Read Answer >>
Related Articles
  1. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  2. Trading

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  3. Trading

    Interest Rate Swaps Explained

    Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
  4. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  5. Trading

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
  6. Personal Finance

    Even Worse News About Airbag Recalls: What to Do

    The recall numbers are even higher than previously estimated. How to look up your car – and what to do if you find it on the recall list.
  7. Managing Wealth

    Managing Interest Rate Risk

    Learn which tools you need to manage the risk that comes with changing rates.
  8. Investing

    PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)

    Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
  9. Trading

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  10. Investing

    GM Gains Time to Prove Airbag Recall Not Necessary (GM)

    Critics fear U.S. auto safety regulators' grace period for faulty airbag recall may set a precedent.
RELATED TERMS
  1. Airbag Swap

    An interest rate swap whose notional value adjusts according ...
  2. Rate Anticipation Swap

    A type of swap in which bonds are exchanged according to their ...
  3. Delayed Rate Setting Swap

    An exchange of cash flows, one of which is based on a fixed interest ...
  4. Bond Market Association (BMA) Swap

    A type of swap arrangement in which two parties agree to exchange ...
  5. Asset Swap

    Similar in structure to a plain vanilla swap, the key difference ...
  6. Basis Rate Swap

    A type of swap in which two parties swap variable interest rates ...
Hot Definitions
  1. Trumponomics

    Trumponomics is a term for the economic policies of President Donald Trump.
  2. Universal Health Care Coverage

    An organized healthcare system that provides healthcare benefits to all persons in a specified region. Many countries, such ...
  3. Davos World Economic Forum

    The annual meeting of the World Economic Forum hosted at Davos—a small ski town in Switzerland—in January each year is among ...
  4. Smart Home

    A convenient home setup where appliances and devices can be automatically controlled remotely from anywhere in the world ...
  5. Efficient Frontier

    A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a ...
  6. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
Trading Center