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I think it is to get the benifit of getting more funds at lower interest rates. It is a global process. It is process fascilitated by LIBOR.
In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, $1 million) and an accrual factor given by the appropriate day count convention. When both legs are in the same currency, this notional amount is typically not exchanged between counterparties, but is used only for calculating the size of cashflows to be exchanged. When the legs are in different currencies, the respective notional amounts are typically exchanged at the start and the end of the swap.
The most common interest rate swap involves counterparty A paying a fixed rate (the swap rate) to counterparty B while receiving a floating rate indexed to a reference rate like LIBOR, EURIBOR, or MIBOR. By market convention, the counterparty paying the fixed rate is the "payer" (while receiving the floating rate), and the counterparty receiving the fixed rate is the "receiver" (while paying the floating rate).
A pays fixed rate to B (A receives floating rate)
B pays floating rate to A (B receives fixed rate)
Currently, A borrows from Market @ LIBOR +1.5%. B borrows from Market @8.5%.
Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of8.65% in exchange for periodic variable interest rate payments of LIBOR +70 bps (0.70%) in the same currency. Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e., imaginary) principal amount. Also note that interest payments are settled in net; that is, Party A pays (LIBOR +1.50%)+8.65% - (LIBOR+0.70%) =9.45% net. The fixed rate (8.65% in this example) is referred to as the swap rate.[2]
At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay50 bps above the par swap rate, the other party has to pay approximately50bps over LIBOR to compensate for this.
the bank does interest rate swap is to reduce the risk
I agree with discussions of Mr. Ganguly.
There are many possible reasons. One example is to manage interest rate risk. For example, if the bank has assets on which it receives a fixed rate of interest, and liabilities on which it pays a floating rate of interest, it is exposed to loss if interest rates go up. Or a profit if they go down. By entering into a swap, it can "lock in" the existing profit/loss.
The obvious answer is to make money. But let us digress and see what these are-the interest rate swaps & how they entered the markets.
The first interest rate swap occurred between IBM and the World Bank in1981. However, despite their relative youth, swaps have exploded in popularity. In1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than15 times the size of the U.S. public equities market.
Plain Vanilla Interest Rate SwapThe most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.
