Interest Rate Swaps – Understanding the Concept
What are interest rate swaps ?
The financial market is ever changing. The currency of every country varies with respect to each other due to their frequent appreciation and depreciation. It is a common occurrence that the value of an American dollar increases or reduced with respect to British pounds, European euros, Japanese yen and Chinese RenMinBi. So, what happens when two countries indulge in currency swap? They have to pay interest to each other on the principle amount.
Now, what if one currency involved in the swap suddenly appreciates with respect to another? There will be a change in the interest rate as well. In order to prevent such ups and down of interest rate, interest rate swaps are fixed. These rated constant and independent of he fluctuating market. Interest rates can also vary based on floating rates. Interest rate swap prevents these losses and gains and maintains a constant flow of funds between the two counterparties.
How is interest rate swap beneficial to a business ?
The biggest advantage of interest rate swap is that it retains the same rate of interest all through the swap period, be it one year or five years. This gives a better scope for businesses to plan out their finances. Interest rate swap also gives a businessperson peace of mind and relief from worrying about constant fluctuations in the market as the swap rate are fixed agreed upon. The deal turns out to be cost effective and fair on both the parties involved in the deal. In the long run, interest swap rates can reduce the cost of business and make the credit swap much more affordable when compared to other ways of funds exchange. Furthermore, interest rate swap provides a common platform for various countries to spread their business globally, notwithstanding the global economical conditions.
Types of interest rate swap
Interest swap rates are of different kinds based on the countries and currencies involved in the deal. Interest rate swap can be fixed between floating and fixed interest rates for swaps of same currencies and different currencies. The two parties involved can set their terms and conditions. Whatever be the type of interest rate swap, they are helpful in providing the much needed security against fluctuating interest rates. This interest rate swap is one of the basic things to understand in swapping of currencies. The decision, however, entirely depends on the counterparties and there is no hard and fast rule about following the principle. These are beneficial for long term swaps.