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Interest Rate Swaps

 

What Are Interest Rate Swaps?

An interest rate swap is a private agreement between two parties to exchange interest rate obligations for a specific period of time. Most often, one party has a fixed interest rate but prefers to have a floating interest rate, and the other party has a floating interest rate but prefers to have a fixed interest rate.

A predictable fixed rate may be desired for budgeting purposes, but also if a borrower wants to avoid exposure to rising interest rates. A floating rate may be desired by a borrower if rates are expected to fall, and by a lender who expects rates to rise.

How Does An Interest Rate Swap Work?

Interest rate swaps are contracts between two parties, often a bank and a company. The two parties create the terms of the contract and customize the agreement in any way they please, including setting the frequency of the payments, the period of the loan, and the principal amount.

The principle of the swap is called the “notional” amount. It is never exchanged and in fact, is only used to calculate the payments. As well, typically, only one party is required to pay the net of the two payments. The floating rate in the agreement is often linked to either the one-, three- or six-month LIBOR (London Interbank Offered Rate).

For example, let’s say investor A has an investment that pays her 2% on $1,000,000 for 3 years. Investor B has an investment that pays him LIBOR (currently 1%) +1% on $1,000,000 for 3 years. Both A and B are receiving the same amount monthly for as long as LIBOR is 1%, or $1,666 = (.02x1,000,000)/12.

Investor A, however, believes rates are rising and would like to have a floating rate. Investor B thinks rates are falling and would like to have a fixed rate.

The two parties decide to enter into an interest rate swap agreement in which Investor B will make monthly payments to Investor A of LIBOR+1% on the notional amount of $1,000,000 for 3 years, while Investor A will make monthly payments to Investor B of 2% each month on the same notional amount for 3 years. As is standard with an interest rate swap, the notional amount of $1,000,000 is not exchanged.

Pros & Cons Of Interest Rate Swap

Rather, profits and losses hinge on any changes in the interest rate. As such, Investor A will benefit if LIBOR rises and Investor B will benefit if LIBOR falls.

When in the following month, LIBOR rises to 1.25%. Investor A will still receive a monthly payment of 2% fixed, or $1,666. However, Investor B receives new LIBOR+1% (now 2.25%), $1875=(.0225x1,000,000)/12, from the original investments.

Based on the rate swap agreement, Investor B owes Investor A $1,875, and investor A owes investor B $1,666. Therefore investor B pays investor A the net amount of $209.

Finding Interest Rate Swaps At Investing.com

At Investing.com significant interest rate swap news can be found on the main news page. The Forward Rates page can also be useful for swap agreements when currencies are involved.

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