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Going long or short on the interest rates

You can go short or long on interest rates with interest rate swaps.

For example, you take a $100,000 loan from a bank with a fixed interest rate of 5%, and a year from now, you will have to repay $100,000+5% = $105,000.

If the rates rise throughout this year, let’s say, to 10%, you still pay your 5% no matter what, so you “saved” the money.

What if you had an opinion that the interest rates will rise from where they are now, how can you profit on this?

You can make an interest rate swap. You take the same loan of $100,000 at 5% per year fixed, but then you lend this money to someone at the floating interest rate.

Assume you were right with your prediction, and in a year time interest rates are sitting at 10%, what happens now? Well, you still will have to pay your $100,000+5% to the bank ($105,000), but the other guy/girl will have to pay you $100,000+10%, which is $110,000, so you make a profit of $110k – $105k = $5,000.

When you took a fixed rate loan, you went “long” on the interest rates, so when they go up, you have to pay less at a predetermined earlier rate. The other party, which took a floating interest rate, went “short” on the interest rates thinking he or she will have to pay less on a loan since the rates will go down, but they went up, so he or she lost money to you.

Two parties can also agree to pay each other interest on the same amount of loan, swapping floating and fixed rates between each other.

Summary

When you take a loan with fixed interest rates –> you go long on rates, because if they rise you pay the smaller fixed interest.
When you take a loan with floating interest rates –> you go short on rates, because if they fall you pay less than initial interest.

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