Discuss the effect of changes in market interest rates on swap values with appropriate examples.

An Interest Rate Swap is a financial contract between two parties exchanging or swapping a stream of interest payments for a 'notional principal' amount on multiple occasions during a specified period. Such contracts generally involve exchange of a 'fixed to floating' or 'floating to floating' rates of interest. Accordingly, on each payment date - that occurs during the swap period - cash payments based on fixed/floating and floating rates, are made by the parties to one another. For each party, the value of an interest rate swap lies in the net difference between the present value of the cash flows one party expects to receive and the present value of the payments the other party expects to make. At the origination of the contract, the value for both parties is usually zero because no cash flows are exchanged at that point. Over the life of the contract, it becomes a zero-sum game. As interest rates fluctuate, the value of the swap creates a profit on one counterparty's books, which results in a corresponding loss on the other's books. The value of an interest rate swap changes with changes in interest rates. For the fixed rate payer (floating rate receiver) the value of the swap increases when interest rates increase. In international market, LIBOR (London Inter-Bank Offered Rate) is the benchmark, or a reference rate in case of floating rate loans. LIBOR is the rate of interest offered by banks on deposits from other banks in EURO market. In India, there is Mumbai Inter-Bank Offered Rate (MIBOR), which can be used as a reference rate. For better understanding let us consider an example: A. Ltd. and B. Ltd., both want to borrow ₹10 crore for 5 years and following rates are offered: A. Ltd. B. Ltd. Fixed Rate 10% 11.20% Floating Rate LIBOR + .3% LIBOR + 1% B Ltd. wants to borrow at fixed rate while A Ltd., want to borrow at floating rate. How can they enter into a swap? From the point of view of swap market, the difference in fixed rates is greater than the difference in floating rates, i.e., 1.20% and .7% respectively. B. Ltd. has a comparative advantage in floating rate borrowing while A Ltd. has a comparative advantage in fixed rate borrowing. This comparative advantage allow a swap to be negotiated. A Ltd. should borrow at 10% fixed rate and B Ltd. borrows at LIBOR + 1% i.e., at floating rate and enter into a swap as follows: In this case, A Ltd. pays LIBOR to B Ltd. and 10% to lenders. It receives 9.95% from B Ltd. The net burden of A Ltd. is LIBOR + .05%. On the other hand, B Ltd. pays 9.95% to A Ltd. and LIBOR + 1% to lenders. It receives LIBOR from A Ltd. The net burden of B Ltd. in 9.95% + 1% = 10.95%. So, A Ltd. is able to borrow at the lesser floating rate of LIBOR + .05% whereas B Ltd. is able to borrow at lesser fixed rate at 10.95%.