Interest Rate Swap

Interest rate swap is contract between two companies through any financial intermediary. This contract is of exchange of  interest rate. In this contract, one company exchanges his fixed interest rate in to floating interest rate and other company exchanges his floating interest rate in to fixed interest rate. This deal is done in international money market or by derivative in OTC market. This is good way to hedge in the fluctuation of interest rates. Main aim of interest rate swap to reduce the cost of debt.  

Interest Rate Swap Example

Interest rate swaps are simply the exchange of one set of cash flows. Generally speaking, swaps are sought by firms that desire a type of interest rate structure that another firm can provide less expensively. For example, let's say B company is seeking to loan funds at a fixed interest rate, but A company has access to marginally cheaper fixed-rate funds. Company A can issue debt to investors at its low fixed rate of 5%  and then trade the fixed-rate cash flow obligations to Company B for floating-rate obligations issued by Company A. Even though Company B may have a higher floating rate than Company A, by swapping the interest structures they are best able to obtain, their combined costs are decreased - a benefit that can be shared by both parties. I again summarize :

A) Company A exchanges his fixed interest rate for floating interest rate through interest rate swap. For this, his obligation will be 5% (Floating LIBOR) - ( 10 BPS + 1.5 basis of points (LIBOR).)

B) Company B exchanges his floating interest rate for fixed interest rate through interest rate swap. For this, his obligation will be 5% interest (Fixed) + (20 BPS + 1.5 BPS)

Types of Interest Rate Swap 

1. Fixed-for-floating rate swap, same currency
2. Fixed-for-floating rate swap, different currencies
3. Floating-for-floating rate swap, same currency
4. Floating-for-floating rate swap, different currencies
5. Fixed-for-fixed rate swap, different currencies

Related : How to Control Foreign Exchange Risk


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Accounting Education: Interest Rate Swap
Interest Rate Swap
Accounting Education
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