Interest Rate Swap is basically a contractual arrangement between two parties which are called "Counterparties". Commonly the counterparties are a Financial Institution and an issuer.
These counterparties agree to exchange the payments which are actually based upon a Principal amount.
This Principal amount is NOT exchanged between the counterparties but the payments are based upon this principal are exchanged. .
Interest Rate Swaps don't generate the new sources of funding themselves. Rather, they convert one Interest Rate Basis to another Interest Rate Basis. For example Floating to fixed interest rate or Fixed Interest rate to Floating.
The Floating Interest Rate is benchmarked to some interest rates such as MIBOR in India.
SWAP is not a lending facility. It's an interest rate management tool which can be used in conjunction with any viable rate lending facility.
Interest Rates Swaps were originally created to allow the multinational companies to evade the exchange controls. However, now, they are used to hedge against / speculate in the changes in the interest rates.
In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a particular currency to the other counter party. The fixed or floating rate is multiplied by a notional principal amount (say Rupees 2 Crore).
How Interest Rate Swaps Work?
In SWAP the parties agree to pay the "the difference between a fixed interest Rate and a series of variable interest rates over an agreed period of time".
Fixed rate is a fixed rate such as 5%, 6% as the case may be
Variable rate is a rate that is linked to a variable rate such as MIBOR or LIBOR (London Interbank Offer Rate )
The agreement can be as follows:
Fixed for Floating Swap Transaction
Floating for Fixed Swap Transaction
We assume that a Party A is a borrower with a 3 year ` 2 crore Variable Rate MIBOR based facility, which rolls over on a quarterly basis at the prevailing 3 month MIBOR Rate. This party, in the current economic environment feels that the Interest rates may rise in near future and feels that the interest rate may go up than the current 5% rates. The party would seek an opportunity to lock in the borrowing cost at 5% rate. But since the party has a Variable Rate based facility , he/ she cannot change it and is exposed to the assumed interest rate hikes in the future.
Here, party A has an option. He/ she enters into an agreement with Party B for a period of 3 years for ` 2 Crore and pay the interest rate of 5% on quarterly settlement dates.
Now, we assume that the MIBOR linked interest rate hikes as party A assumed and it becomes 6%. But since party A has a contract with party B that it will pay only 5% interest rate as per the swap agreement. So, now the party B will have to compensate party A by 1% of ` 2 crore. This amount will be used by party A to offset the interest rates hiked by 1%. So party A is saved from this hike in interest rate.
Now if the MIBOR linked interest rate decreases and becomes 4%. Party A will pay 4% for his ` 2 Crore loan which is a Variable Rate MIBOR based facility. Here it saves 1% , but since with party B it has an agreement to pay 5%, party A will compensate the party B for this balance.
The interest rate swap is a hedging in which if there is NO variation in the interest rates, it is a zero sum game but if the rates vary, one wins at the cost of another.