Question 6.RQ.3: What are the benefits of an interest swap agreement and how ...

A swap agreement can be a useful hedging device. A business with a floating rate loan agree-ment, for example, may believe that interest rates are going to rise, whereas a business with a fixed rate agreement may believe that interest rates are going to fall. By entering into a swap agreement, they can both hedge against risk. Swap agreements may also be used to exploit capital market imperfections, such as where one business has an advantage over another when negotiating interest rates.
A swap arrangement involves two businesses agreeing to assume responsibility for the other’s interest payments (although, in some cases, a bank may act as counterparty to a swap agreement). Typically, a business with a floating-interest-rate loan will swap interest pay-ment obligations with a business with a fixed-interest-rate loan. The arrangement is usually negotiated through a bank. Legal responsibility for interest payments still rests with the business that entered into the original loan agreement. Thus, the borrowing business may continue to make interest payments to the lender in line with the loan agreement. However, at the end of an agreed period, a compensating cash adjustment between the two swap parties will be made.