Interest Rate Swap (IRS)

An interest Rate Swap is a financial contract in which two contracting parties agree to give channels of cash flows over the life of the contract. One contracting party pays a fixed interest rate on the principal and the other party to the contract repays at the floating rate for the same sum, which is usually referred to as a floating rate to fixed-rate Interest Rate Swap. Interest Rate Swap can also be floating to floating, which means that one of the components is floating.

Interest Rate Swap Primary Goal

The IRS’s primary goal is to mitigate constituents’ interest rate risk and allow them to construct the asset/liability composition that is most suited to their specific cash flows.

Interest-rate swaps are different products that are unrelated to the actual loans for which the customer desires to offset interest rate risk. However, the objective is to determine the internal consistency of the interest charged on such loans.

When the bank and the borrower decide about the interest-rate swap, variable rates and fixed rates are swapped. The customer receives from the bank the variable rate of interest on its loan, less any variable price differences, and then returns the bank the fixed rate decided upon in the interest rate swap. This structure shields the customer from rising interest rates. Variable price differences must still be paid by the customer, and they are not covered in the interest-rate swaps.

Interest Rate Swap Example

Assume Company A has to raise $85 million in order to obtain another entrant into their business. They shall be eligible to take out loans with a 2.7 % interest rate in their home nation., but they shall be also eligible to borrow with a 2.2 % interest rate outside of their home nation. The caveat is that they are required to release the bond in terms of a foreign currency, which really is vulnerable to variation depending on interest rates in the home nation.

For the term of the bond, Company A might get into an interest rate swap. Company A would pay the other trading party 2.2 % interest throughout the life of the contract getting closed, according to the terms of the arrangement. When the bond expires, the corporation would swap $85 million at the accepted exchange rate, eliminating any vulnerability to any changes related to exchange rates.

Different Types of Interest Rate Swaps

The three basic forms of interest rate swaps are as follows:

• Fixed-to-Floating forms of interest rate swaps, 
• Floating-to-Fixed forms of interest rate swaps, 
• Floating-to-Floating forms of interest rate swaps.

In a fixed-to-floating swap, one firm receives a fixed rate and pays a floating rate because it believes that a floating rate would provide more cash flow. The exchange is constructed to match the fixed-rate bond’s maturity and cash flow, and the two fixed-rate payment flows are summed.

A floating-to-fixed swap occurs when a corporation desires to get a fixed rate, such as to hedge interest rate risk. If a corporation cannot get a fixed-rate loan, it can receive money at a floating rate and then enter into a swap to acquire a fixed rate.

Finally, a float-to-float swap is a two-party agreement to trade variable interest rates. It is also known as a basis swap. A corporation can, for example, switch from minimum-month LIBOR to a slightly higher number of months LIBOR because the rate is more appealing or it meets other payment flows. A LIBOR rate, for example, might be switched for a T-Bill rate. 

Conclusion

We learned about interest rate swap, interest rate swap examples and other topics related to Interest Rate Swap (IRS).

Clients can use Interest Rate Swaps to regulate or hedge both fixed or floating resources and obligations. The interest payment computed by Fixed Rate and Floating Rate is exchanged between two counterparties in an Interest Rate Swap. If a customer pays a fixed rate and obtains a floating rate, the client can offset its interest rates if market interest rates continue to rise. If a customer paid a floating rate and received a fixed rate, the client will gain if the market interest rate falls, but will pay a greater cost if the market interest rate rises.