See Also:
What is Compound Interest
Effective Rate of Interest Calculation
Interest Expense
Nominal Interest Rate
Interest Rate Swaps
An interest rate swap is a contract in which two parties exchange streams of interest payments. The parties do not exchange the underlying principal amounts, only the streams of interest payments.
Interest Rate Swap Characteristics
Interest rate swap agreements have predetermined interest rates or spreads and predetermined maturities. The interest payments are based on a hypothetical amount called the notional principal amount. The two counterparties exchange interest payments according to the agreement until the contract expires.
Interest Rate Swap Example
Often the two parties involved in interest rate swap agreements are a company and a large bank. The company may not be satisfied with the borrowing costs available to it in the marketplace. For example, the company may only have access to loans with floating interest rates. But the company prefers a loan with a fixed interest rate.
That company can arrange an interest rate swap with a large bank that allows it to pay interest based on a fixed rate to the bank in exchange for payments based on a floating rate from the bank.
Advantages of Interest-Rate Swaps
There are several reasons why a company would want to enter into an interest-rate swap.
Hedging
First is interest rate swap hedging. The interest rate swap is a technique for hedging risk of unfavorable interest rate fluctuations.
For example, if a company has a loan with a floating interest rate, and the company expects the floating rate to rise substantially, then that company can enter into an interest rate swap to switch its floating rate for a fixed rate. Then, if and when the floating rate rises substantially, the company will not be affected because it will be paying a fixed rate.
Reduce Uncertainty
Also, an interest rate swap agreement can reduce uncertainty. If a company has a floating rate loan, they may not know what sort of interest rate payments they will be paying throughout the duration of that loan. The floating rate could rise or fall, and either way it could affect the finances of the company. In order to eliminate uncertainty, the company could enter into an interest rate swap agreement with a bank that allows the company to make fixed payments instead of variable payments.
Reduce Cost of Loan
And finally, an interest rate swap can reduce the cost of a loan. Depending on the specifics of the transaction, a company may be able to enter into an interest rate swap that allows it to pay a lower fixed interest rate to a swap trader than it would have had to pay for a fixed interest rate with a lender.
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