• Interest rate Swap

    Interest rate swap is the most common type of swap which is called the “Plain Vanilla”. It is nothing but an exchange of fixed rate loan with a floating rate loan or vice versa. This is used to get the comparative advantage in the loan market to avail loan at the cheapest interest rate. To avail the cheapest interest rate loan, one company may borrow at floating rate while they prefer fixed rate and the other company may borrow at fixed rate while they prefer floating rate. Here they use interest rate swap to swap the interest rate payment between themselves. After the swap agreement, the first company will pay the fixed rate interest and the second company will pay the floating rate interest. In this way both the companies will get the desired benefit.

    Characteristics of Interest rate swap

    • The interest is calculated based on the principal amount which is called as the notional principal.
    • At the initiation of the interest rate swap, the fixed rate is chosen such that the present value of all the floating rate payments should be equal to the present value of the all the fixed rate payments.
    • The swap value has to be zero at the time of initiation. Later both the companies will follow either the fixed rate or the floating rate based on some other reference rate.
    • Floating rate increases with the market interest rate. If the interest rate increases, then the fixed rate payer will receive higher interest payment and will have positive value.
    • If the interest rate decreases, then the fixed rate payer will receive lower interest payment and will have negative value.

    Example

    Let us see the below example to understand interest rate swap completely

    • Suppose one company A is more comfortable with paying interest at floating rate and another company B is more comfortable of paying interest at fixed rate.
    • Company A can easily borrow loan at fixed rate of interest while company B can easily borrow loan at floating rate of interest. So they will do the same and swap the interest payment with each other.
    • Suppose the notional principal is USD 100,000 and floating rate interest is determined by the LIBOR rate which is currently at 9%. The fixed rate of interest is 9% as well.
    • The interest payment is due after every one year. Company A will receive the fixed rate of interest from company B and pay the same to the lender.
    • The same way Company B will receive the floating rate of interest from company A and pay the same to the lender.
    • Suppose after 1 year the floating rate of interest increases to 10%. The transactions will be
      • Company A will get USD 9000 interest payment at fixed rate of 9% from company B and pay to the lender.
      • Company B will get USD 10,000 interest payment at floating rate of 10% from company A and pay to the lender.
      • Here company A pays USD 10,000 and receives USD 9,000 and company B pays USD 9,000 and receives USD 10,000.
      • If they could have borrowed at the same rate of fixed interest let’s suppose 9%, Company B could have made a profit of USD 1,000 from this interest payment.
      • Suppose after 1 year the floating rate of interest increases to 8%. The transactions will be
    • Company A will get USD 9000 interest payment at fixed rate of 9% from company B and pay to the lender.
    • Company B will get USD 8,000 interest payment at floating rate of 8% from company A and pay to the lender.
    • Here company A pays USD 8,000 and receives USD 9,000 and company B pays USD 9,000 and receives USD 8,000.
    • If they could have borrowed at the same rate of fixed interest let’s suppose 8%, Company A could have made a profit of USD 1,000 from this interest payment.

    This is how a company can hedge the risk arising from the adverse movement in the interest rates by using the interest rate swap.

    Interest rate swap involves significant credit risk as one counterparty can default on the agreed interest rate payment. It can be for the current required payment or any payment due in the future. That’s why credit rating of both the counterparties are checked before deciding the swap rate, which may lead to higher rate of interest for party with lower credit rating.

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