Question

Describe the characteristics and benefits of interest rate swaps compared with other forms of interest rate risk management, such as forward rate agreements and interest rate futures

Answer 1

Interests rate swaps are interest rate exchanges between parties usually involving exchanging a fixed rate of interest with that of a fluctuating rate of interest payment or vice versa. The interest rates swaps are done between two mutually agreeing companies or between a company and a bank to exchange receivables or payables among themselves. Benefits of interest rate swaps:

1. If the company anticipates that the interest rates in the future will increase, then it can swap its floating rate payments with a fixed rate payment option and vice versa. It helps in hedging for receivables and payables.

2. Uncertainty regarding future payments is reduced through interest rate swaps usually in the case of floating rate payments. In case of floating rate payments, the company may have to pay the interest as per the rate prevailing on the date of payment which can be higher or lower and the same can be mitigated through a fixed rate swap.

3. It helps in reducing the cost of debt for the companies and also plan for future financing needs in an efficient manner.