Interest rate swaps are over-the-counter trades that allow two businesses to exchange interest rates with one another in a way that benefits both of them. Reasons for doing such a trade can vary, but commonly it is done to allow companies access to loans that differ from those types for which they normally qualify. Swaps may also occur as a means of balancing a portfolio, hedging against possible rate increases or taking advantage of a preferred rate structure. At the end of the swap the only amount of money that exchanges hands is the difference between the total of the amounts due.
A floating-for-floating interest rate swap occurs when both of the parties involved have a floating loan, also known as a variable rate loan. Most commonly the two loans come from different reference rate indexes, usually either the London Interbank Offered Rate, LIBOR, or the Tokyo Interbank Offered Rate, TIBOR, but they can come from the same index as well. Payments on the loans are usually set up to fall on different days, especially if the loans are from the same index.
In a fixed-for-floating interest rate swap, one of the companies involved has a fixed-rate loan and the other one has a floating-rate loan. The two agree to trade loans, with each of the companies paying the portion, or leg, of the loan for which the other was originally responsible. This means that the company that actually acquired the fixed loan will make the payments on the floating leg, and the original borrower on the floating loan will make payments on the fixed leg. This allows companies access to loan types for which they might not otherwise qualify.
The third type of interest rate swap is the fixed-for-fixed swap, where both parties involved have fixed-rate loans. This swap is used when the two businesses involved are using different currencies. This is particularly beneficial to a company that wants to expand into a country where it has not previously operated. Currency exchange costs are eliminated and international companies benefit from being able to access lower interest rates in the country where the loan originated.
When companies deal with interest rate swaps, the principle amount does not change hands. Instead, after the pre-determined swap period is over, the company that owes the greatest amount of money will pay the other company the difference between what the two owe during the settlement process. So, for example, if Company X ends up owing a total of $500,000 on the swap while Company Y owes only $450,000, the only money that actually changes hands is $50,000, paid from Company X to Company Y.
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