An interest rate swap refers to a contractual agreement where one party commits to exchanging future interest payments for another based on a predetermined principal amount. Typically, these swaps involve trading a fixed interest rate for a variable one, or vice versa. This exchange is done to mitigate the impact of interest rate fluctuations or to secure a slightly lower interest rate than would have been achievable without the swap.
Additionally, a swap can extend to trading one form of variable rate for another, termed as a basis swap. This arrangement involves exchanging one type of floating interest rate for a different one.
Understanding Interest Rate Swaps
Interest rate swaps involve exchanging one stream of cash flows for another. These transactions occur over the counter (OTC), allowing two or more parties to customize contracts according to their specific requirements. The flexibility of swaps enables various customization options.
These swaps are commonly employed when a company can readily access funds at a particular interest rate but has a preference for a different type of rate structure.
Types of Interest Rate Swaps
There are three different types of interest rate swaps: Fixed-to-floating, floating-to-fixed, and float-to-float.
Floating-to-Fixed
A company lacking access to a fixed-rate loan might opt for a floating-rate loan and simultaneously engage in a swap to attain a fixed rate. This involves aligning the floating-rate terms, reset dates, and payment schedules on the loan with those on the swap, effectively offsetting each other. Consequently, the fixed-rate side of the swap serves as the company's borrowing rate.
Fixed-to-Floating
Consider a scenario involving TSI, a company aiming to secure a fixed interest rate through bond issuance for its investors. However, TSI believes it can optimize its cash flow by shifting to a floating rate. To achieve this, TSI engages in a swap arrangement with a banking counterparty. In this swap, TSI receives a fixed rate while paying a floating rate.
The swap is structured to align with the maturity and cash flow terms of the fixed-rate bond. Both fixed-rate payment streams are consolidated. TSI collaborates with the bank to select the preferred floating-rate index, typically opting for the London Interbank Offered Rate (LIBOR) with varying maturities such as one, three, or six months. TSI then receives LIBOR plus or minus a spread, which factors in prevailing market interest rates and the company's credit rating.
Float-to-Float
At times, companies engage in a swap to modify the nature or duration of the floating rate index they pay, termed as a basis swap. For instance, a company might transition from paying three-month LIBOR to six-month LIBOR, driven by more favorable rates or to align with other payment schedules. Another option is switching to an alternate index, like the federal funds rate, commercial paper, or the Treasury bill rate, based on varying preferences or market conditions.
Why is it called ‘interest rate swap’?
An interest rate swap involves the exchange of future interest payments based on a specified principal amount between two parties. Financial institutions commonly employ interest rate swaps to mitigate losses, manage credit risks, or engage in speculation. These swaps are tailored to each party's needs and are traded on over-the-counter (OTC) markets, with the most prevalent type being a vanilla swap - a fixed rate exchanged for a floating rate.
What does an interest rate swap look like?
Consider a scenario where Company A issues $10 million in two-year bonds with a variable interest rate linked to the London Interbank Offered Rate (LIBOR) plus 1%. If LIBOR stands at 2%, Company A, fearing potential rate hikes, seeks out Company B. Company B agrees to pay Company A the annual LIBOR rate plus 1% for two years on the $10 million principal. In return, Company A pays Company B a fixed 4% rate on the same $10 million for two years. In the event of significant interest rate increases, Company A benefits, whereas Company B gains if rates remain stable or decrease.
What kinds of interest rate swaps are there?
The primary types of interest rate swaps include fixed-to-floating, floating-to-fixed, and float-to-float swaps. In a fixed-to-floating swap, one party receives a fixed rate while paying a floating rate, expecting stronger cash flow from the floating rate. Conversely, in a floating-to-fixed swap, a company might seek a fixed rate to hedge against interest rate exposure. Lastly, a float-to-float swap, also termed a basis swap, involves two parties exchanging variable interest rates, such as swapping LIBOR for a Treasury bill (T-bill) rate.
Conclusion
An interest rate swap involves an arrangement where parties agree to swap one set of interest payments for another during a predetermined duration. These contracts, known as derivatives, are traded over the counter (OTC) and can be tailored by the involved parties to suit their specific requirements.
Typically, these swaps involve exchanging fixed-rate payments for floating-rate payments, or vice versa. They serve the purpose of either mitigating the impact of varying interest rates on finances or securing a more favorable borrowing rate.
Get the latest daily news related to market analysis, updated trading news, and reliable technical analysis on DCFX #TheSuperApp equipped with a comprehensive feature set covering 70+ global instruments. So, download the app now and start trading!