An Interest Rate Swap allows a corporate to hedge the interest rate risks arising on account of lending and borrowings made at fixed or floating rates. There is no exchange of principal amount and the interest payments are calculated only on notional principal amounts.
In an IRS the corporate enters into a contract with the bank to exchange a stream of interest payments for a notional principal amount on multiple occasions during a specified period. The contract usually involves exchange of a fixed to floating or floating to floating rates of interest between the company and the bank.
Accordingly, cash payments are made, either by the bank or the company on each payment date based on the difference between the fixed/floating or floating/floating rates as the case may be. The floating benchmark rates are normally the NSE Mibor / Reuters Mibor or the appropriate T-Bill yield.
Trade date : Date when the counter-parties agree on swap conditions
Effective date : Date when the interest obligations start to accrue
Maturity date : Date when the swap terminates
A) Fixed rate > Floating rate
On fixing date, 3m Mibor is say 5.00%
Hence, floating rate is (5.00+1.00) = 6.00%
On effective date, Customer Pays IndusInd Bank (6.00%-5.00%)= 1.00%
B) Fixed rate < Floating rate
On fixing date, 3m Mibor is say 7.00%
Hence, floating rate is (7.00+1.00) = 8.00%
On effective date, IndusInd Bank Pays Customer (8.00%-7.00%)= 1.00%
While banks and financial institutions are allowed to enter into swaps for hedging their exposures as well as for market making, corporate customers are allowed to enter into IRS only for the purpose of hedging the interest rate risk on the underlying asset/liability.