Transfer of interest rate streams
without transferring underlying
debt.
Benefits
The chief advantage of an interest rate swap is that it limits a company’s exposure to interest rate fluctuations, and thus reduces risk. By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line with management’s appetite for interest rate risk.
Where there is a positive quality spread differential, a further benefit is the opportunity for arbitrage. This enables each party to take advantage of the other’s credit-worthiness in the swap.
Other pluses include increasing the certainty of an issuer’s future obligations, saving money should interest rates decline (here, the party paying a floating rate will be the beneficiary of a rate drop), the option of revising your debt profile to benefit from anticipated future market conditions, and reducing the amount of debt service.
Interest rate swaps generally involve minimal cash outlay. It is usual that on a payment date only the difference between the two payment amounts is paid to the entitled, rather than an exchange of the full amount of interest.
Risk Management
A company’s management may find interest rate swaps useful as a means of reducing the risk interest rates will drop by switching variable rate interest income for a fixed rate income stream. Typically, the other party is more interested in increasing profit potential and is willing to take on added risk by swapping a fixed rate interest stream for one that is variable. Both parties benefit by better matching financial positions to company needs.
Financing Access
In some cases, a company may have access to financing with a variable interest rate, but not fixed rate borrowing. An interest rate swap can allow this firm to tap into the creditworthiness of another firm to get the type of financing management desires.
Ref
http://www.investinganswers.com/financia...
http://www.investopedia.com/articles/opt...
http://www.investopedia.com/ask/answers/...
http://www.moneycrashers.com/interest-ra...
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explain how can interest rate swaps reduces the bank interest rate risk?
