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.

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