Friday, August 10, 2012

What Are Rate Swaps?

By Brad Wilson


Rate swaps are agreements made between two specific parties that allow these parties to exchange one interest rate for another. As an example, many companies can use this swap agreement to exchange a fixed payment for one that is floating. This type of swap is basically used to reduce a company's exposure to fluctuations or to obtain a lower interest rate.

There are still some other reason these tools can be used. In the following we are going to discuss several reasons interest rate swaps are utilized by companies every single day.

Why Interest Swaps Are Used

Taking Risks- One of the most beneficial uses of rate swaps for companies is their ability to hedge risk. When a company want to avoid risk with an interest rate, they exchange that interest rate. This however, can impact their overall cost as the variances in the different interest rates can produce a significant impact as well.

Costs- Companies use interest rate swaps to lower their costs. This will not only allow them to lower the amount of interest associated with certain assets but also the fees inclined with other debts.

Profits- The main purpose of most big businesses is to make money. But most times, businesses find it hard to stay out of the red sue to factors like a fixed interest rate and a fixed cash flow. Mosttimes, companies swap fixed interest rate for a variable rate which may either increase or decrease. If the rate increases, but the cash outflow still remains the same, the swap is actually profitable for the business, and they are able to stay out of the red.

Debt- While rate swaps can be profitable on their own, they can also offset and optimize debt in the same manner. Let us assume that a company has a variable rate and a fixed amount of debt. If the floating rate turns out high, then the company may have to borrow funds to cover their interest. Through this exchange, they can be able to afford their debt and the rate has the potential to be profitable.

How You Can Use These Swaps

When two parties agree to swap interest, for any of the specific reasons listed above, they typically use the most common type of swap: the plain vanilla swap. This is often the exchange of two cash flows normally in the same currency and paid as agreed by the parties involved.

You can use this type of swap to exchange a floating rate for a fixed one for a certain period of time. The period for the coupon, and depends on the agreement between the parties. The amount of interest exchange also varies, although most investors use LIBOR, or the London Interbank Offer Rate, as a base for the variable rate. This is the typically interest rate used by banks in London when deposits from Eurodollar market banks make deposits.

Before you go into interest rate swap, think of how these derivatives could benefit you. How can they help you to stay out of the red, reduce costs, manage debt or manage risk in the market? If so, then you can consider using rate swaps in the future.




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