In principle, interest rate swaps occur when two parties – one of which earns fixed interest and the other receive variable interest – agree that they prefer the credit agreement to the other party. The party that is paid on the basis of a variable interest rate decides that it would prefer a guaranteed fixed interest rate, while the party receiving fixed-rate payments thinks that interest rates could rise and take advantage of this situation when it occurs – to get higher interest rates – it would prefer to have a variable interest rate that would increase if there was a general trend of rising interest rates. (a) Discuss and apply traditional and fundamental methods of interest rate management, including: In this example, companies A and B enter into an interest rate swap contract with a face value of $100,000. Company A estimates that interest rates are likely to rise over the next few years and aims to create a potential risk for a potential gain from a variable interest rate return, which would increase if interest rates were actually rising. Company B currently enjoys variable interest rate returns, but is more pessimistic about the outlook for interest rates as it expects them to decline over the next two years, which would reduce its return. Company B is motivated by the desire to protect against possible interest rate cuts, in the form of a fixed return on interest rates that are frozen during the period. Loans or deposits may be with a financial institution and the FRA with a totally different result, but the net result should offer the company a targeted fixed interest rate. This result will be achieved by rewarding the amounts paid to the FRA supplier or received by the Fra, depending on the state of interest rates. For more information on our outlook for interest rates, monetary policy and investment impact, see «What`s next for interest rates.» If a swap becomes unprofitable or a counterparty wants to remove the interest rate risk from the swap, that counterparty can create a clearing swap – essentially a reflection of the initial swap – with another counterparty to «cancel» the effects of the initial swap.
Interest Rate Hedging Agreement