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Sumit Gulati
An interest rate swap is a contractual agreement entered into between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction there is no foreign exchange component to be taken account of
An agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates,
or to obtain a marginally lower interest rate than it would have been able to get without the swap.
In a fixed-for-floating swap agreement, one party agrees to pay the fixed leg of the swap, with the other party agreeing to pay the floating leg of the swap. The fixed rate is the interest charged over the life of a loan and does not change. Fixed-for-floating rate swap, different currencies : Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in one currency to a floating rate asset/liability in a different currency, or vice versa.
Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate asset/liability or vice versa.
In a floating-for-floating interest rate swap agreement, both parties agree to pay a floating rate on their respective legs of the swap. Floating-for-floating rate swap, same currency Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the two indexes widening or narrowing.
In fixed-for-fixed interest rate swaps, both parties agree to a fixed interest for their respective legs of the swap.
The interest rate does not change over the life of the loan for both parties.
Investors most commonly use fixed-for-fixed interest rate swaps when they are dealing with different currencies. Companies often use fixed-for-fixed interest rate swaps when they are building or expanding their business in a foreign country
insurance companies
mortgage companies investment vehicles and trusts government agencies and sovereign states
To obtain lower cost funding To hedge interest rate exposure To obtain higher yielding investment assets To create types of investment asset not otherwise obtainable To implement overall asset or liability management strategies
Companies dont have to liaise directly with another company, banks intermediate. They can be used to lock into an interest and exchange rate for longer periods. They do not require frequent monitoring and reviewing. Used to hedge against adverse interest rate fluctuations. Premiums paid are lower than options. They are more flexible than options and futures.
Banks decrease the benefit companies receive from the transaction Company can default on interest payments i.e. counter party risk yet bank intermediation should reduce this A company with absolute advantage over another company can become worse off in the SWAP deal It is advisable to trade only with companies that have good credit ratings
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