An interest rate swap is a contract between two parties that allows them to exchange interest rate payments. The typical scenario involves one party switching their payments from a fixed interest rate to a floating one, or vice versa. The motivation behind this is usually to take advantage of changing economic conditions and obtain a more favorable payment structure. The key element of this contract is that the principal amount on which the interest is calculated doesn’t change hands.
Related Questions
1. How does an interest rate swap work?
An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter. Usually, at the time of the contract initiation, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price.
2. Why use an interest rate swap?
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Companies use interest rate swaps for several reasons, such as hedging against interest rate exposure, altering the characteristics of their liabilities, or to get cheaper financing. Interest rate swaps can also provide investors with a higher margin of income.
3. What is the risk with interest rate swaps?
While interest rate swaps can provide several benefits, they also come with their share of risks. These include market risks due to changes in the prevailing interest rates, credit risks where one party may default on its obligation, mismatch risks due to changes affecting cash flow timing, and basis risks if reference rates diverge significantly.
4. What’s meant by a ‘plain vanilla’ interest rate swap?
Plain vanilla interest rate swap is the simplest type of interest rate swap agreement. It involves the exchange of a fixed interest rate for a floating interest rate. The parties decide on the frequency of the interest payments and the maturity of the swap agreement when setting up the contract.
5. Can an interest rate swap be cancelled?
Yes, an interest rate swap can be cancelled before its maturity date. However, the cancelling party might have to pay a fee, particularly if the interest rate environment has changed to the benefit of the other party.