Question

Please explain, why a company would enter into an interest rate swap agreement.

[10 marks]

Answer 1

An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.Interest rate swaps are the exchange of one set of cash flows for another. Because they trade over the counter (OTC), the contracts are between two or more parties according to their desired specifications and can be customized in many different ways. Swaps are often utilized if a company can borrow money easily at one type of interest rate but prefers a different type.For example, consider a company named TSI that can issue a bond at a very attractive fixed interest rate to its investors. The company's management feels that it can get a better cash flow from a floating rate. In this case, TSI can enter into a swap with a counterparty bank in which the company receives a fixed rate and pays a floating rate. The swap is structured to match the maturity and cash flow of the fixed-rate bond and the two fixed-rate payment streams are netted. TSI and the bank choose the preferred floating-rate index, which is usually LIBOR for a one-, three- or six-month maturity. TSI then receives LIBOR plus or minus a spread that reflects both interest rate conditions in the market and its credit rating.company that does not have access to a fixed-rate loan may borrow at a floating rate and enter into a swap to achieve a fixed rate. The floating-rate tenor, reset and payment dates on the loan are mirrored on the swap and netted. The fixed-rate leg of the swap becomes the company's borrowing rate.