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What is the concept of interest rate swaps?
Interest rate swap is an agreement between parties to exchange interest rates. Let’s say, we have two parties (first party and second party). Then, the most commonly used interest rate agreement is “first party agrees to pay at fixed interest rate to second party and second party agrees to pay at floating interest rate to first party”. Mostly banks, corporations and investors use interest rate swaps.
Reasons to use
The reasons to use the interest swap rates are explained below −
- Offset risk of floating interest rate.
- To lock the future fixed rate.
- Leverage rate between the currencies.
- To speculate on the predicated fluctuation rates.
The two types of interest swap rates are as follows −
Fixed to floating − Exchange between fixed interest rate for a floating interest rate or exchange between floating interest rate to fixed interest rate.
Float to float − Exchange of floating rates between two benchmarks. For example, one benchmark may be LIBOR and the other may be US prime rate.
Working of the interest swap rates is explained below −
- Notional Principal amount for interest swap is selected.
- Both types of interest and amount of interest to be swapped are defined.
- Signing of interest rate swap agreement is carried out.
The advantages of the interest swap rates are listed below −
- Stable payment streams.
- Businesses can maintain additional smaller emergency cash reserves.
- Banks get best interest rates.
- Payers can take future risk (in case).
- Cheaper rates for payers.
The disadvantages of the interest swap rates are listed below −
- Increase in risk.
- Can upset an overall market.
- Offset risk of their contract.
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