Interest Rate Swap, Currency Swap, Credit Default Swap - Desklib

FINANCE & INVESTMENT
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Interest Rate Swap
An interest rate swap is defined as a financial derivative which is deployed by the companies
for the exchange of interest rate payment with one another. The interest rate swaps are useful
only when there are two parties one which wants to receive a payment linked with the
variable interest rate and another party who wants to receive a fixed rate of interest thereby
reducing the underlying risk. Theoretically, it acts as a win-win situation for both the parties
involved. This is because one party is able to hedge the underlying risk of floating interest by
being able to avail a mutually agreed fixed rate of interest whereby the other party gets to
hold a conservative asset with potential rewards. Also, it is noticeable that interest rate swaps
tend to lead to a zero sum game where one party would benefit and the other would lose
based on the prevailing interest rate at the time of determined date when maturity of swap is
achieved. The interest rate swaps are traded over the counter and agreement between the
buyer and seller is required with regards to two main aspects i.e. swap length (which would
ascertain the maturity date) and swap terms (including frequency of payments along with
underlying structure). An example of interest rate swap is demonstrated as shown below.
Consider there are two firms i.e. ABC Ltd and XYZ Ltd. They enter into an interest rate swap
with a nominal value of $ 10 million and maturity of 1 year. XYZ is offered an annual fixed
rate of 5% by ABC while in return ABC would be received LIBOR +2% as the two parties
believe that LIBOR should be around 3%. Assume that at the end of the maturity period of
interest rate swap, the LIBOR is 2.75%, thus XYZ would be given 5% of $10 million or $ 0.5
million as interest payment by ABC. However, XYZ would pay (2.75% +2%) or 4.75% of $
10 million or $ 0.475 million as interest payment to ABC. In the process, XYZ gains $ 0.025
million since LIBOR decreases where ABC lost the same amount.