Interest Rate SwapSwapping interest rates for a better cash flow

Just as there are different types of debt instruments, there are also different types of interest rates too.

There’s a fixed interest rate, one that doesn’t change until the end of the debt instrument’s term.

For example, if a debt instrument has a fixed interest rate of 10%, the borrower will have to pay the lender 10% until the end of its term.

Then there’s the floating interest rate (a.k.a. floating rate) that rises or falls in tandem with a particular benchmark or the general market conditions.

For example, a bond may have a floating rate of the London Interbank Offered Rate (LIBOR) plus 1%.

This means that the interest that the borrower will pay will depend on the LIBOR.

Now think of this scenario: your business can issue a bond with a competitive fixed interest rate.

However, your business’s analysts say that a floating rate is more beneficial for the business’s cash flow.

What are you to do in this situation?

Should you just issue the bonds and ignore your analysts?

Well, you might want to consider using an interest rate swap.

Basically, an interest rate swap is an exchange of interest payments between two parties.

In this article, we will be exploring what an interest rate swap is.

What does it do? How does one execute an interest rate swap?

How does it work for the involved parties?

Does an interest rate swap provide benefits for either party?

We’ll try to answer these questions as we move along with the article.

What is an Interest Rate Swap?

An interest rate swap is a type of forward contract in which two counterparties agree to exchange future interest payments based on a specified principal amount.

In most cases, interest rate swaps include the exchange of a fixed interest rate for a floating rate or vice versa.

The primary reason for using an interest rate swap is to reduce or increase exposure to fluctuations in interest rates.

Another reason would be to obtain a lower interest rate that would have been impossible without the use of an interest rate swap.

In some cases, an interest rate swap may involve the exchange of different types of floating rates.

This type of interest rate swap is generally referred to as a basis swap.

For example, an interest rate swap may involve the exchange of a LIBOR floating rate for a T-bills floating rate.

Just like any other type of swap, interest rate swaps are only traded over the counter (OTC).

They are never traded on public exchanges.

But because of this, interest rate swaps can be highly customizable.

The counterparties may design the interest rate swap according to their preferred specifications.

For example, the payment dates could be regular or irregular, the reset dates of the floating rate could be irregular, the counterparties may include mandatory break clauses, etc.

Depending on which counterparty exchanges the fixed or floating interest rate, an interest rate swap may increase or decrease exposure to the fluctuations in the general market conditions.

Swapping a floating rate for a fixed interest rate decreases exposure.

On the other hand, swapping a fixed interest rate for a floating rate increases exposure.

Fixed Interest Rate VS Floating Rate

Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate or vice versa.

To better understand interest swaps, we must first understand the concept of fixed and floating interest rates.

A fixed interest rate is an interest rate on a debt or other type of security that doesn’t change until the end of the security’s term.

For example, if a 3-year bond has a fixed interest rate of 12%, the borrower will have to pay 12% interest until the bond’s maturity.

On the other hand, a floating interest rate is one that changes over time, depending on an underlying benchmark index or the general market conditions.

Usually, the floating rate is based on the London Interbank Offered Rate (LIBOR).

Other benchmark indices are the federal funds rate, the Treasury bill rate, etc.

Since a fixed interest rate doesn’t change until the end of the security’s maturity, it doesn’t have exposure to fluctuations in the general market conditions.

Whereas, a floating rate has high exposure to such fluctuations.

With the help of an interest rate swap, a borrower may choose to decrease or increase exposure to these fluctuations.

Types of Interest Rate Swaps

There are three main types of interest rate swaps, which are the following:

• Fixed-to-floating
• Floating-to-fixed; and
• Float-to-float

Fixed-to-Floating

A fixed-to-floating interest rate swap is a contractual agreement between two counterparties in which one party swaps the interest cash flows of a fixed-rate interest instrument with those of a floating rate instrument held by the other party.

In short, it exchanges a fixed interest rate for a floating rate.

For example, let’s say that Company A can issue a bond with a competitive fixed interest rate to its shareholders and investors.

However, the company’s analyst predicts that a floating rate will result in a better interest cash flow.

In such a case, company A may opt to enter into an interest rate swap with a counterparty that can issue a floating rate bond.

Under such a swap, company A will receive a fixed rate and will pay a floating rate.

Floating-to-Fixed

A floating-to-fixed interest rate swap is essentially the opposite of a fixed-to-floating swap.

It occurs when one party swaps the interest cash flows of a floating rate instrument with those of a fixed interest rate instrument held by another party.

For example, a company currently only has access to floating rate loans.

However, this company prefers to pay interest at a fixed rate.

It doesn’t want its future interest cash flow to depend on changes in the interest rate.

In such a case, the company may opt for a floating-to-fixed interest rate swap.

What this swap does is effectively make the borrowing rate of the company a fixed rate.

A floating-to-fixed interest rate swap is ideal for those who want to hedge interest rate exposure.

Float-to-Float

A float-to-float interest rate swap (a.k.a. basis swap) occurs when two counterparties want to exchange the type or tenor of the floating rate that they pay.

For example, a company may opt to swap a three-month LIBOR with a six-month LIBOR or vice versa.

Or a company may want to switch to a different index such as from LIBOR to the federal funds rate.

How Does an Interest Rate Swap Work?

An interest rate swap typically occurs when two parties- one wanting to pay or receive fixed interest payments, while the other wanting to pay or receive floating-rate payments- mutually agree to swap their interest cash flows.

The party receiving or paying a fixed interest rate will receive or pay a floating rate instead.

On the other hand, the party receiving or paying a floating rate will receive or pay a fixed rate instead.

There are several reasons why one would want to enter into an interest rate swap.

For example, a company paying a fixed interest rate believes that the interest rate may fall in the coming years.

As such, to take advantage of such a situation, this company will enter into an interest rate swap to pay a floating rate instead.

On the other hand, a company that wants to hedge interest rate exposure would want to pay a fixed interest rate.

If such a company pays a floating rate, it may enter into an interest rate swap to pay a fixed interest rate instead.

An interest rate swap only exchanges the interest payments between the two parties.

It does not exchange the debts of the counterparties.

A good interest rate swap contract will clearly state the terms of the agreement.

For example, it clearly states the respective interest rates that each party will pay to the other party.

It will also include the payment schedule.

The notional principal amount should also be clearly stated.