Interest Rate Swap

Interest rate swap is an agreement between two parties where the two parties decides to exchange interest obligations or receipts for an agreed period of time. Under interest rate swap there is no exchange of principal, it involves only exchange of interest between two parties.

Interest rate swap is dependent on an agreed notional principal amount and is usually transacted on a fixed for floating rate basis. So for example if the borrower of a loan is worried about the rising interest rates than he or she will enter into swap agreement with other party who is willing to take that risk, that borrower will pay only predetermined rate and if interest rate rises other party will have to pay the difference of interest rate.

So if a person has taken floating rate loan at 10 percent interest rate and the interest rate rises to 12 percent then other party will pay the 2 percent difference and borrower will be at advantage in this case. However if the interest rate goes to 8 percent then the borrower will pay difference of 2 percent to other party with which the agreement of interest rate swap was entered. As one can see that interest rate swap allows you to manage interest rate risk arising out of the borrowing, however it has the risk that since this kind of swap are over the counter product, there are chances that counter party may not fulfill its contractual obligations as set out in interest rate swap.

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