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Understanding the interest rate swap

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Understanding the interest rate swap Powered By Docstoc
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In the world of finance, swaps are derivatives which come in various forms, and an interest rate
swap offers the involved parties the opportunity to exchange interest payment cash flows.

And is often applied in the strategic management of liabilities, and fixed or floating assets, they
do not hold risk on the principal sum. Speculation on interest rate margin changes is also
possible where unfunded bond exposures are involved, thus creating another way of deriving
some earnings.

In the early days interest swaps were used to enable transnational firms to avoid exchange
controls. And nowadays counterparties are in a position to enter into mutual agreements with
which fixed or floating rate payments are made to one of the counterparties.

Thus cash flow in the agreed currency changes hands on the basis of calculations arrived at by
multiplying the applicable rate on the notional principal amount.

The nature of swaps is such that their value is pegged at zero on origination, and assumes
value when counterparty offers are made. On the other hand, fixed-for-floating swaps are
structured in a fashion that permits the conversion of a fixed asset/liability to a floating rate
asset/liability or otherwise.

The floating-for-floating rate swaps work in a manner that allows individuals to make use of
them for the purposes of hedging or speculating on the spread in relation to the widening or
narrowing indexes.

Additionally, floating for floating rate swaps are involved in cases where two sides cite the same
index, even if the dates of remittances vary. And speculation is almost impractical with the
floating for floating swaps, but come with a range of benefits as regards asset-liability
management.

Interest rate swaps are utilized for speculative aims by investors, and hedge funds anticipating
movements in interest rates. However, interest rate swaps are known to expose investors and
others using them to interest rate risk and also credit risk.

Risk relating to interest rate is generated from variations in the floating rate, while credit risk on
the swap is born out of being 'in the money', in case the opposite party defaults.

In the course of a swap term, a standardized appraisal process is employed, although over time,
the forward rates shift and the PV of the variable-rate part of the swap tends to behave in a
divergent fashion, that is in respect of the fixed-rate side of the swap.

This element translates to the swap being an asset or a liability respectively on the two parties
involved, thus ushering dissimilar fortunes.

				
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posted:2/12/2013
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George Chapungu George Chapungu
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