What is Interest Rate Swap?
Interest rate swap is an agreement between parties to exchange obligation to pay interest.
For effective Hedge, using interest rate swap following three conditions should be met.
- Duration and maturity date of borrowings should be same.
- One party to the swap should be subject to fixed interest rate and other should be subject to variable interest rate payment.
- Principle amount of borrowings should be same.
Uses of Interest Rate Swap
Interest rate swap can be used for following causes.
Switching Between Types of Interest Rate
Interest rate swap can be used to switch between variable and fixed interest payments to make interest expense consistent with the cash flows expected by the Business. Arrangement for this kind of swap is known as ‘plain vanilla’ or generic swap.
Business having volatile revenue will prefer variable interest rate so that cash inflows and outflows can be matched.
Business having even revenue will prefer fixed interest rate so that cash inflows and outflows can be matched.
In Interest rate swap both businesses will pay interest to opposite lenders, but in case of default by any one party to interest rate swap other will be still liable for interest payments to its original lender. Lenders are not involved in interest rate swap arrangement in anyway.
If one party gets bankrupt or cease trading, then other party will suffer. In that case, opposite party should immediately stop interest payments to different lender.
Interest rate swap results in savings in cost of penalty incurred in early repayment of loan and transaction costs of borrowing new loan under different type of interest rate.
Borrow Loan at More Competitive Terms
Business wishing to borrow loan in foreign currency may not be able to borrow at all or at competitive terms due to lack of credit standing or recognition in that foreign country.
Business in foreign country facing same problem can be contacted for arranging swap. In this arrangement, both Businesses will raise loan in their home currency but pay interest to different lender in foreign currency.
Interest rate swap can be used for hedging long-term interest rate risk.
