Interest rate swap

everybody needs money and business can not run without money. But when one company takes loan from bank then it has to pay interest eithr in fixed rate or in floating rate. If the interest rate is based on floating rate then company has risk of incresing interest rate. What is the solution? Among many , interest rate SWAP is one financial instrument which can reduce interest rate risk.

interest rate swap is recently developed financial tool in which two parties exchange their cash flow generated from interest thereby reducing interest rate risk. How it works?

There must be two parties to exchange the interest rate. One party gives interest of other party and other party does the same. Confused!!!!!!!!!!!!!

We can explain it with one example. Company A which has better credit rating so it can get loan at lower interest rate which is based on floating rate i.e. LIBOR (London Interbank offering rate) e..g at LIBOR +50bp or at fixed interest rate i.e. lets say 10%. At the same time another party B has lower credit rating and can get loan at LIBOR + 150 bp or at fixed rate of 9%.

here party A can get lower interest based on LIBOR but wants to fix its interest rate however if it takes at fixed rate it has to pay 10% and party B can get lower interest at fixed but wants floating rate. If they on their own they can not get cheaper loan and even can not reduce interest rate risk. So swap is one alternative. Among many types of interest rate swap floating to fixed rate swap is available and one bank lets say Deutsche Bank can work as intermediator to deal the swap. How it works here we can show.

Company A pays a fixed rate to the bank at 9.5% and bank pays fixed rate of 9%to company B. At the same time Company B pays a Floating rate i.e. LIBOR + 125 bp to bank and bank pays to company A LIBOR+100 bp.

Now net effect to companoes:

Company A: -9.5%+LIBOR+100bp-LIBOR + 50bp ( to own bank)= 9% fixed

here what ever happens to the floating interest rate net effect to company A will remain 9%

Company B:+9%- LIBOR+125bp-10% ( to own bank)= LIBOR + 225bp

In our previous paragraph we explained that company A wants fixed interest and it got and B wants floating rate and it also got. Now bank has also got the margin . This is a typical win win situation for all parties and interest rate risk has been also reduced.

The first interest rate swap was done between IBM and World bank in 80's and now it has become very popular financial tool.