Interest rate swap is a derivative contract that allows two parties to exchange the interest rates between two parties. When parties want to invest they have to take a loan. A loan can either be on a fixed rate or a floating rate of interest. A swap will occur when “Party A” having a fixed rate of interest wants to swap its interest payments by committing to pay floating interest rate payments of “party B” that commits to pay the fixed interest rate payments for “party A”.
The contract needs a notional principal that would be same amount for example $100,000 for both parties. Party A has a fixed rate of 5% and party B has a floating rate of (Libor + 2%). Assuming Libor is 3.10%, as a result of swap, party A will pay floating rate interest of 5.10% for Party B, which will pay fixed rate of 5% for party A. In reality only the interest payments difference is paid by one party which in this case is Party A paying $100 [(5.10%-5%)*$100000].
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