A fixed for floating interest rate swap involves two parties A and B that agree the following:
- Party A pays Party B a fixed rate on a pre-agreed notional capital amount
- Party B pays Party A a floating rate, which most of the times is tied to LIBOR plus an agreed amount of points
In this setting, Party A stands to benefit if the agreed floating rate rises after the effective date of the period covered by the swap.
Fixed for Floating interest rate swaps can be used by property investors that have mortgages with adjustable rates in order to hedge the risk of rising interest rates and increasing mortgage payments that may result in negative cash flows.
Note though that using interest rate swaps entails risk, since if the interest rates do not rise as expected but falls instead after the effective date of the swap, Party A will incur losses as the cost of the swap (the fixed rate that Party A pays to Party B) will be higher than the benefit of holding it (the floating rate paid by Party B).
However, if floating rates do indeed rise then the property investor (Party A) will be able to mitigate the negative effect of increasing mortgage payments due to rising interest rates with the positive cash flow receipts from the swap.
