In case of a rising interest rate scenario the borrower is exposed to the risk of increasing his interest burden. He may opt for a fixed rate loan but this may not always be possible due to bad market conditions, credit rating etc and as a result of which his cost of borrowing in fixed rate will be pretty high. Given this scenario the only solution he may have is to go for a floating rate liability and then swap the floating rate liability into a fixed rate liability. This floating rate liability can be swapped with someone who has an exact opposite requirement or request a bank to arrange for a swap.

The following diagram illustrates the case in which an intermediary, e.g. a bank, is involved in a swap deal between two counter parties. Borrower A has a floating rate loan, but would prefer a fixed rate loan. There is another borrower B who has a fixed rate loan, but would prefer a floating rate loan. The intermediary can now match these two borrowers as described in the following diagram.

A manufacturing company embarks on a project for which it borrows USD 4 million working capital on a floating interest rate basis, payable quarterly for two years. Since the treasurer of the company felt that the floating rate payments will involve serious risks, he decides to enter into a swap with a bank and convert the same into a fixed rate loan. The bank now swaps the floating rate payments into a fixed rate at 12%. The resultant cash flow arising out of the transaction is illustrated below.

Happy studying


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