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Interest rate swaps or Vanilla swaps are non-standardized, un-regulated, over the counter deal between 2 entities. Let’s say a corporation C has taken a loan from bank B with a floating interest rate (which is the normal case). These interest rates are based on the London Inter-Bank Offered Rate (LIBOR) which keeps varying. So, there is a factor of volatility in terms of money C has to pay to bank B in the form of interest. What C can do is, it can buy fixed interest rate swap with financial institution FI with the same notional capital (loan capital with bank B). What it means is that?, C now will pay a fixed interest rate decided in the beginning to FI, and FI will pay C the variable interest rate money (Again based on LIBOR). So essentially what it means is that C will pay a fixed amount to FI and FI will cover C’s volatility risk from variable interest rates of loan from bank B. That way C will know exactly how much money it will have to pay in total.
In Interest rate swaps, both could be the winners.
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