An Interest Rate Swap is an agreement between two parties (bank and borrower) to exchange a series of interest payments on a common principal amount. Usually the interest rate paid by one party is fixed for the duration of the swap, while the rate paid by the other party is tied to a reference floating interest rate. Your original loan can be a term loan or operating loan with BA or USD LIBOR borrowing options.

A Floating to Fixed Swap is the most common form of Interest Rate Swap. It lets your company convert its variable floating-rate on a loan to what is effectively a fixed interest rate, to protect against potential interest rate increases. Other variations include a Fixed to Floating Rate Swap and a Cross Currency Swap, which allow a company to protect against both currency and interest rate risk by converting principal and interest flows from one currency into another currency.

Benefits to your company:

1. Flexible risk management to protect against market risk and once approved, borrowers can enter into a swap at any time.
2. Customization with respect to the forward start date, repayment schedule, maturity, currency and amendments.
3. Unwinding a swap before maturity will result in either a market gain or loss depending upon the movement in market rates whereas with a term loan, prepayment will only result in a penalty payment.
4. An Interest Rate Swap changes the effective interest rate you pay. It does not change any feature of your existing loan or any other part of your company's balance sheet.

An example:

Suppose your company has a term loan to finance a long-term asset of $5,000,000 with TD Bank with a BA stamping fee of 1½%. You want to fix the interest rate for the next five years on the term loan, so you enter into a Floating to Fixed Swap with TD Bank. You agree to make interest payments to TD at a fixed rate of 5.5% on a principal amount of $5,000,000 and TD agrees to make interest payments to you at a three-month BA reference rate. The original terms of the loan are unchanged, and you will continue to issue BA's every three months. The net effect of the swap is to fix the market interest rate at 5.50% for five years and your all in rate will be the swap rate of 5.5% plus the stamping fee of 1½ %.

See the diagram below:

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