What is Interest Rate Swap?
The term “interest rate swap” refers to the derivative contract between two parties who agree to exchange one stream of interest payments for another, on the basis of a particular pre-determined principal amount. Typically, interest rate swaps are used in the exchange of a fixed interest rate for the floating interest rate. These derivative instruments are traded on over-the-counter (OTC) only and not on public exchanges.
Explanation of Interest Rate Swap
In an interest rate swap, two parties – one of which makes fixed rate interest payments and the other of which makes floating rate interest payments – mutually agree to interchange each other’s loan arrangement.In such contracts, simply the interest payments get swapped and the parties don’t take ownership of each other’s debt. Effectively, they merely pay each other the difference in interest payments. If the fixed interest rate is higher, then the party (Company 1) obligated to pay the fixed interest as per the contract will pay the difference between the fixed interest and floating interest to the other party (Company 2) and vice versa.
How does Interest Rate Swap Work?
Typically, after the counterparties have decided to enter into an interest rate swap agreement the following steps are involved:
- The counterparties need to agree on the notional principal amount based on which the future interest payments have to be calculated.
- Next, they must decide on the type and amount of interest to be exchanged. This interest payment will represent the cash flows flowing in and out of the swapping entities.
- Finally, they seal the deal by signing the financial contract. Mostly, commercial or investment banks act as the intermediary in such swap transactions.
Example of Interest Rate Swap
Following are the examples are given below:
Let us assume that PQR Inc. has to raise $10 million from the debt market to fund its new expansion project. The company offered a variable interest rate, which currently stood at4%. Now, the company is concerned that the prevailing market scenario indicates a high probability of an increase in the benchmark interest rate in the near term. So, it decided to enter into an interest rate swap agreement with TQZInc. who currently pays a fixed interest rate of 5%. Consequently, as per the swap contract, PQR Inc. will be pay a fixed interest rate of 5% to TQZ Inc., while TQZ Inc. will pay a variable interest rate (currently 4%) to PQR Inc.
At the beginning of the swap contract, PQR Inc. has to pay 1% (= fixed 5% – variable 4%) of the notional principal to TQZ Inc. as the swap spread. However, in case the benchmark interest rate increases by 2%then the variable rate will become 6%, then TQZ Inc. will have to pay PQR Inc. 1% (= variable 6% – fixed 5%) of the notional principal as the swap spread. On the other hand, if the benchmark interest rate remains stable or goes down, then PQR Inc. will have to pay TQZ Inc. This is an example of a fixed to floating rate swap.
Let us assume that ASD Inc. had recently raised a loan with a floating interest rate indexed to the 3-month LIBOR. However, now the company intends to move to a 3-month EURIBOR. Instead of exchanging the benchmark index, the company can opt for an interest rate swap agreement with another party whose debt is currently indexed to the 3-month EURIBOR. Basically, this is an example of a floating to floating rate swap wherein the exchange of one type of benchmark index for another has taken place.
Similarly, ASD Inc. can also swap its benchmark index from 3-month LIBOR to 6-month LIBOR. This is another type of floating to floating rate swap.
Interest Rate Swap Rates
The below table provides the interest rate swap rates for monthly money swaps:
Source: Chatham Financial
Interest Rate Swap Valuation
The net present value (NPV) of the two streams of interest payments must be the same at the beginning of the transaction, which means that both the counterparties pay an equal amount of money over the tenure of the underlying asset.All the future interest payments to be made during the life of the bond is estimated, which is then discounted using the expected inflation to arrive at the NPV of the transaction. It is easier to calculate the NPV for the fixed rate bond given that the periodic payment is equal, while it is very tricky in the case of the floating rate bond as it is liked to a benchmark (say LIBOR), which can always change.
Why Invest in Interest Rate Swap?
The investors should invest in interest rate swaps as it helps in:
- Gauging the interest rate perception in the bond market.
- Making decisions pertaining to taking a loan now or later.
Risks of Interest Rate Swap
There are two major risks associated with interest rate swaps. They are- interest rate risk and counterparty risk.
- The interest rate risk is driven by the fluctuations in the interest rates and it can result in significant losses.
- The counterparty risk refers to the possibility that one or some of the counterparties will default on their payment.
So, it can be seen that interest rate swap may seem a little complicated at first, but if one understands the mechanics, then it can prove to be a very useful tool for businesses to manage their debt efficiently. To sum up, an interest rate swap contract requires two counterparties who wish to change their existing interest rate arrangement and have contrasting preferences in terms of interest payments.
This is a guide to Interest Rate Swap. Here we also discuss the introduction and how does it work? along with major risks associated with interest rate swaps. You may also have a look at the following articles to learn more –