What is Interest rate Swap?
An Interest rate swap is a contract between two parties to exchange interest rate between them over the period of time.
The two parties can come to an agreement whereby both parties will reduce their costs of borrowings. Swap are generally terminated by agreeing a settlement interest rate, generally the current market rate.
Types of Interest rate Swaps
There are two main types of interest rate swaps:
- Coupon Swaps
- Basis Swaps
Coupon Swap:
In Coupon swap, one party makes payment at a fixed rate of interest in exchange for receiving payments at a floating rate (which changes for each payment). The other party pays the floating rate and receive the fixed rate.
Basis Swap:
In a basis swap, the parties exchange payments on one floating rate basis for payments on another floating rate basis.
Point to be noted that, most Interest rate Swaps are coupon swaps.
SWAP Procedures
Interest rate swaps involves two parties agreeing to exchange interest payments over an agreed period of at least one year end typically longer.
A swap may be arranged with a bank, or a counter party may be found through a bank or other financial intermediary. Fees will be payable in bank is used.
A Bank may be able to find a counterparty in more markets than if the company seeking the swap tried to find the counterparty itself.
Advantages of Swaps
- Swaps are flexible and the arrangements costs of swaps are significantly less than terminating an existing loan and taking a new one.
- Swaps allow capital restructuring by changing the nature of interest commitments without renegotiating with lenders
- Swaps can be used to manage interest rate risk by swapping floating for fixed rate debt if rates are expected to rise. Swaps can also be used to swap a variable rate for a fixed rate investments if interest rates are expected to fall.
- Swaps are relatively easy to manage
- If a company’s future cash flows are uncertain, it can use a swap to ensure it has a periodical fixed rate commitments.
Disadvantages of SWAP
- Difficult to identify a counter – party
- Counter – party may not want to swap the same amount with same maturity
- Swap can not be terminated without the mutual agreement of counter party.
Risks of Swaps
| Counter Party Risk | |
| Position or Market Risk | Risk of |
Worked Examples
- In May 2017, Stelvio financed the purchase of a warehouse with a $ 5 million ten year floating rate loan at LIBOR + 3% pa. Fred Hughes believes that interest rates are going to rise over the next five years and he would like to protect the company against interest rate risk. he has been in contact with Zeta Leasing Ltd. (Zeta) which has a policy of keeping a certain proportion of their borrowings at a fixed rate. Zeta would like to swap $5 million of its fixed-rate loans to a floating rate. A bank has offered to arrange the swap and Fred has agreed that all the benefits from the swap will be shared equally between Stelvio and Zeta. Stelvio can borrow at a fixed rate of 5% pa. Zeta can borrow at a fixed rate of 3% pa and at a floating rate of LIBOR + 2% pa. LIBOR is currently .60% pa.
Requirements:
- Demonstrate how the proposed interest rate swap between Stelvio and Zeta would be implemented
- Calculate the initial difference in annual interest rates for Stelvio if it enters into the interest rate swap and calculate the minimum amount by which LIBOR will have to rise for the swap to break even.
Solution:
a) Firstly, it is necessary to calculate the interest rate differentials:
| Stelvio | Zeta | Differentials | |
| Fixed Rates | 5% | 3% | 2% |
| Floating Rates | LIBOR + 3% | LIBOR + 2% | 1% |
| Net Difference | 1% | ||
| Shared Equally | 0.50% each |
The interest rates that can be achieved through the swap are:
| Stelvio | Zeta | |
| The fixed market rate for Stelvio | 5% | – |
| The Floating market rate for Zeta | – | LIBOR + 2% |
| Less: the differential | 0.50% | 0.50% |
| Rates achieved through the swap | 4.50% | LIBOR + 1.5% |
Cash flows would be: LIBOR from Zeta to Stelvio and Fixed of 1.5% from Stelvio to Zeta.
b) If LIBOR remains at 0.60% without the swap Stelvio would pay 0.60% + 3% = 3.60%.
With the swap Stelvio would be paying 4.5%
LIBOR will have to rise to 4.5% – 3% = 1.5% for the swap to break even in interest terms.