Interest Rate swaps

Interest Rate swaps:

This is generally used by large enterprises, and are traded over the counter.

Suppose Company A take Loan of Rs.1 Crore from Bank A at a floating rate of LIBOR+2% This 2% is risk premium with regard to Company A. and there is another company B that has taken loan From Bank B @11% for an amount of Rs. 1 crore.

This simply means Company A is paying Floating rate of interest and Company B is paying Fixed rate of Interest. Company A estimates that there will be an increase in the LIBOR which will result in increased interest expense(for example if LIBOR will be 10% then interest rate will become 12%) on the other hand Company B assumes that in future Floating interest rate will be lower.

Now the Story begins here, Company A will search for type of companies like  B in this case and vice-versa which is ready to exchange the interest rate. This task of searching is facilitated by ann intermediate party called swap bank. Here Principal amount i.e 1 crore will not be exchanged(I.e it will be assumed as notional). The only thing either party has to pay is the difference in the interest amount.

This can be used as a hedging instrument, and also can be used by speculators. since one party whose interest was variable earlier can be made fixed and the ones whose interest was earlier fixed can be made variable.

Investopedia defines Interest rate swaps as:

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. 

A swap can also involve the exchange of one type of floating rate for another, which is called a basic swap. (https://www.investopedia.com/terms/i/interestrateswap.asp)