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. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  2. Should you calculate Value at Risk (VaR) for counterparty credit risk?

    Value at risk (VaR) calculations may be helpful for risk management when trading credit default swaps and other derivatives ... Read Full Answer >>
  3. For what financial instruments is a modified duration relevant?

    The modified duration is a formula used to calculate the percent change in the price of a financial instrument when there ... Read Full Answer >>
  4. What is the difference between derivatives and swaps?

    Derivatives are securities with prices dependent on one or multiple underlying assets. Common derivatives include forward ... Read Full Answer >>
  5. Why is tenor important on credit default swaps?

    Tenor – the amount of time left on a debt security's maturity – is important in a credit default swap because it coordinates ... Read Full Answer >>
  6. What kinds of derivatives are types of forward commitments?

    A derivative is a type of security in which the price of the security is dependent on underlying assets. A derivative could ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  2. Mutual Funds & ETFs

    UCO Vs. UWTI: Two Different Leveraged Oil ETFs

    Find out more about the ProShares Ultra Bloomberg Crude Oil ETF and VelocityShares 3x Long Crude Oil ETN, and the mechanics and differences of these funds.
  3. Mutual Funds & ETFs

    UGAZ Vs. GASL: Two Different Leveraged Gas ETFs

    Find out more about the VelocityShares 3X Long Natural Gas ETN and the Direxion Daily Natural Gas Related Bull 3X ETF and the differences between these ETFs.
  4. Mutual Funds & ETFs

    ETF Analysis: Direxion Small Cap Bear 3X

    Find out more about the Direxion Daily Small Cap Bear 3X ETF, the characteristics of TZA and the suitability of the Direxion Daily Small Cap Bear 3X ETF.
  5. Investing Basics

    Understanding Total Return Swaps

    A total return swap is a contract in which a payer and receiver exchange the credit risk and market risk of an underlying asset.
  6. Investing

    4 Structured Product Types Wealthy Clients Love

    High-net-worth investors find structured products appealing for a variety of reasons. Here's a look at four types.
  7. Stock Analysis

    Playing Rising Rates with Ultra-Short Term Bonds

    With rising rates likely, investors may want to consider adding a dose of ultra-short bonds to their portfolios. Here are some ETFs to consider.
  8. Investing Basics

    Explaining Currency Swaps

    A swap that involves the exchange of principal and interest in one currency for the same in another currency.
  9. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  10. Economics

    Effects of OIS Discounting for Derivative Traders

    The use of OIS discounting has important implications for derivative valuations and could positively or negatively impact a trader's profit or loss.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Reference Equity

    The underlying equity that an investor is seeking price movement ...
  3. ISDA Master Agreement

    A standard agreement used in over-the-counter derivatives transactions.
  4. Circus Swap

    A combination of an interest rate swap and a currency swap in ...
  5. Non-Deliverable Swap - NDS

    A currency swap between major and minor currencies that is restricted ...
  6. LIBOR-in-Arrears Swap

    A swap in which the interest paid on a particular date is determined ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!