An interest rate swap is an unregulated over-the-counter (OTC) derivative contract between two parties to exchange one stream of interest payments for another. These contracts are valid for a specific period and are usually used to exchange fixed-rate interest payments for floating-rate interest payments on dates specified by the parties. While fixed interest rates are determined by the expected interestrates, floating rates are pegged to a base rate such as the LIBOR (London Interbank Offered Rate).
An interest rate swap is based on a notional principal amount, which is used to calculate the amount payable by both the parties. However, this principal amount in never exchanged.
Interest rate swaps are used by commercial banks, insurance companies, investment banks, lenders, mortgage companies and government agencies. A typical interest rate swap transaction has a corporation, an investor or a bank on one side and an investment firm or a commercial bank on the other.
Interest rate swaps are fast gaining popularity among investors, speculators and banks, as these transactions are mostly based on market expectations for interest rates. While the total notional value of the swap market was $865.6 billion in 1987, it exceeded the $250 trillion mark by mid-2006, according to the International Swaps and Derivatives Association.
Types of Interest Rate Swap
There are several types of interest rate swaps:
ï‚· Fixed-for-floating rate swap in same currency: This type of swap allows one party to pay fixed interest payments, while receiving payments from the other party in floating interest rates and vise versa. This is the most popular form of rate swaps and is called a vanilla swap.
ï‚· Floating-for-floating rate swap in same currency: This type of interest rate swap is used when floating rates are based on different reference rates. For example, one interest rate could be pegged to the LIBOR, while another to the TIBOR (Tokyo Interbank Offered Rate). Companies opt for this type of swap to reduce the floating interest rate applicable to them and receive higher variable interest payments. It also helps to extend the maturity date of loans.
ï‚· Fixed-for-fixed rate swap: This swap is used only when both parties are dealing in different currencies and involves the exchange of interest payments carrying predetermined rates. This swap helps international companies benefit from lower interest rates available to domestic consumers and avoid currency conversion costs.
Benefits of Interest Rate Swap
The benefits of interest rate swaps are:
ï‚· Portfolio managers can regulate their exposure to interest rates and alter the yield curve in a favourable direction.
ï‚· Speculators can benefit from a favourable change in interest rates.
ï‚· since interest rate swaps do not involve the exchange of the principal amount, it eases the transaction.
ï‚· Companies with fixed rate liabilities can enter into swaps to enjoy the benefits of floating rates and vice versa, based on the prevailing economic scenario.
ï‚· Financial institutions can use these swaps to overcome interest risk exposure and remain profitable.
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps.
The Swaps Market
Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter(OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. (For background reading, see Futures Fundamentals and Options Basics.)
The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, 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 than 15 times the size of the U.S. public equities market.
Plain Vanilla Interest Rate Swap
The 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 principalon 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. (For related reading, see How do companies benefit from interest rate and currency swaps?)
LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments.
Plain Vanilla Foreign Currency Swap
The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.
Who would use a swap?
The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (i.e., liabilities) and earns a fixed rate of interest on loans (i.e., assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities.
Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing.
For example, consider a well-known U.S. firm that wants to expand its operations intoEurope, where it is less well known. It will likely receive more favorable financing terms in theUS. By then using a currency swap, the firm ends with the euros it needs to fund its expansion.
Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this.
Buy Out the Counterparty
Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent.
Enter an Offsetting Swap
For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.
Sell the Swap to Someone Else
Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty.
Use a Swaption
A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2..
Conclusion
Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for.
ii.
If the company consolidated company wish to raise 3 years, £2,000,000 floating rate finance. And have two alternatives then
Alternative A: floating rate finance at LIBOR + 1.2%
Alternative B: fixed rate finance at 9.4, together with an interest rate swap at a fixed annual rate of 8.5% against LIBOR with a swipe arrangement of 0.5% flat payable up front.
For alternative A it comes to £212000/annum
For alternative B it comes to £178000/annum
So the difference comes to £34000/annum.
