However, the forward curve of the LIBOR is constantly changing. Over time, with interest rates changed by the curve and credit spreads, the balance between the green zone and the blue zone will change. If interest rates fall or remain lower than expected, the « beneficiary » will gain fixed (green surface will grow relative to blue). If interest rates rise and remain higher than expected, the « beneficiary » loses (blue extends relative to green). 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. ABC Company and XYZ Company enter into a one-year interest rate swap with a face value of $1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a libor plus 1% rate, as both parties believe that LIBOR will be about 4%.
At the end of the year, ABC XYZ will pay $50,000 (5% of $1 million). If the libor is trading at 4.75%, then XYZ will have to pay $57,500 (5.75% out of $1 million) because libor plus 1 must be paid. Interest rate swaps have become an indispensable tool for many types of investors, but also for corporate treasurers, risk managers and banks, because they have so many potential uses. This includes a currency swap (also known as a « cross-exchange swap ») between parties wishing to exchange capital and interest from one currency to another. Currency sweatshirts can exchange fluctuating or variable prices. Most users of interest rate swaps are companies, investors and banks. Governments also use interest rate swaps. A good interest rate swap contract clearly indicates the terms of the agreement, including the respective interest rates each party must pay, as well as the payment plan (. B for example monthly, quarterly or annual). In addition, the contract indicates both the start date and the expiry date of the swap agreement and both parties are bound by the terms and conditions of the agreement until the expiry date.
Loans or investments are not negotiated or modified: the parties only exchange the interest rates they pay for their loans or receive from their investments. Note that while both parties get what they want from an interest rate swap – one party receives protection against the risk of a fixed interest rate, while the other receives the risk of a potential gain from a variable rate – one party will eventually reap a financial reward, while the other will suffer a financial loss.