Question

Explain why would a company engage in an interest rate swap over other means of managing risk?

Answer 1

Answer-

Interest rate swap

Interest rate swap is an interest rate derivative which involves exchange of interest rates between two parties.

If one wants to secure a fixed cost of debt service but not want to opt for traditional fixed rate loan an interest rate swap is the best option.

If one party thinks of reducing the risk interest rates  by switching to variable rate interest income for a fixed rate income stream and the other party is interested in increasing profit potential and is willing to take on added risk by swapping a fixed rate interest stream with a variable rate interest stream.

Both parties benefit by better matching financial positions to company needs.

The advantages of interest rate swap are-

1) If a company have access to financing with a variable interest rate, but not fixed rate borrowing then interest rate swap can allow the firm to tap into the creditworthiness of another firm to get the type of financing it needs.

2) Swaps gives the borrower flexibility in funding source from the interest rate risk and allows the borrower to secure funding to meet its needs and gives the borrower the ability to create a swap structure to meet its specific goals.

3) It gives prepayment benefits in which the borrower has bilateral means that the swap might be an asset and the borrower would receive the value of that asset.

4) The interest rate swap usually leads to the lowest rate in which floating-rate loan with a swap results in the lowest possible rate for the borrower.