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Interest Rate Swaps Explained – Definition & Example

An interest rate swap is a financial derivative that companies use to exchange interest rate payments with each other.

Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead.

Each group has their own priorities and requirements, so these exchanges can work to the advantage of both parties.

How Interest Rate Swaps Work

Generally, the two parties in an interest rate swap are trading a fixed-rate and variable-interest rate. For example, one company may have a bond that pays the London Interbank Offered Rate (LIBOR), while the other party holds a bond that provides a fixed payment of 5%. If the LIBOR is expected to stay around 3%, then the contract would likely explain that the party paying the varying interest rate will pay LIBOR plus 2%. That way both parties can expect to receive similar payments. The primary investment is never traded, but the parties will agree on a base value (perhaps $1 million) to use to calculate the cash flows that they’ll exchange.

The theory is that one party gets to hedge the risk associated with their security offering a floating interest rate, while the other can take advantage of the potential reward while holding a more conservative asset. It’s a win-win situation, but it’s also a zero-sum game. The gain one party receives through the swap will be equal to the loss of the other party. While you’re neutralizing your risk, in a way, one of you is going to lose some money.

Interest rate swaps are traded over the counter, and if your company decides to exchange interest rates, you and the other party will need to agree on two main issues:

  1. Length of the swap. Establish a start date and a maturity date for the swap, and know that both parties will be bound to all of the terms of the agreement until the contract expires.
  2. Terms of the swap. Be clear about the terms under which you’re exchanging interest rates. You’ll need to carefully weigh the required frequency of payments (annually, quarterly, or monthly). Also decide on the structure of the payments: whether you’ll use an amortizing plan, bullet structure, or zero-coupon method.

To illustrate how a swap may work, let’s look further into an example.

ABC Company and XYZ Company enter into one-year interest rate swap with a nominal value of $1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1%, since both parties believe that LIBOR will be roughly 4%. At the end of the year, ABC will pay XYZ $50,000 (5% of $1 million). If the LIBOR rate is trading at 4.75%, XYZ then will have to pay ABC Company $57,500 (5.75% of $1 million, because of the agreement to pay LIBOR plus 1%).

Therefore, the value of the swap to ABC and XYZ is the difference between what they receive and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a gain of $7,500, while XYZ realizes a loss of $7,500. Generally, only the net payment will be made. When XYZ pays $7,500 to ABC, both companies avoid the cost and complexities of each company paying the full $50,000 and $57,500.

Pros: Why Interest Rate Swaps Are Useful

There are two reasons why companies may want to engage in interest rate swaps:

  1. Commercial motivations. Some companies are in businesses with specific financing requirements, and interest rate swaps can help managers meet their goals. Two common types of businesses that benefit from interest rate swaps are:
    • Banks, which need to have their revenue streams match their liabilities. For example, if a bank is paying a floating rate on its liabilities but receives a fixed payment on the loans it paid out, it may face significant risks if the floating rate liabilities increase significantly. As a result, the bank may choose to hedge against this risk by swapping the fixed payments it receives from their loans for a floating rate payment that is higher than the floating rate payment it needs to pay out. Effectively, this bank will have guaranteed that its revenue will be greater than it expenses and therefore will not find itself in a cash flow crunch.
    • Hedge funds, which rely on speculation and can cut some risk without losing too much potential reward. More specifically, a speculative hedge fund with an expertise in forecasting future interest rates may be able to make huge profits by engaging in high-volume, high-rate swaps.
  2. Comparative advantages: Companies can sometimes receive either a fixed- or floating-rate loan at a better rate than most other borrowers. However, that may not be the kind of financing they are looking for in a particular situation. A company may, for example, have access to a loan with a 5% rate when the current rate is about 6%. But they may need a loan that charges a floating rate payment. If another company, meanwhile, can gain from receiving a floating rate interest loan, but is required to take a loan that obligates them to make fixed payments, then two companies could conduct a swap, where they would both be able to fulfill their respective preferences.

In short, the swap lets banks, investment funds, and companies capitalize on a wide range of loan types without breaking rules and requirements about their assets and liabilities.

Cons: Risks Associated with Interest Rate Swaps

Swaps can help make financing more efficient and allow companies to employ more creative investing strategies, but they are not without their risks. There are two risk types associated with swaps:

  1. Floating interest rates are very unpredictable and create significant risk for both parties. One party is almost always going to come out ahead in a swap, and the other will lose money. The party that is obligated to making floating rate payments will profit when the variable rate decreases, but lose when the rate goes up. The opposite effect takes place with the other party.
  2. Counterparty risk adds an additional level of complication to the equation. Usually this risk is fairly low, since institutions making these trades are usually in strong financial positions, and parties are unlikely to agree to a contract with an unreliable company. But if one party ends up in default, then they won’t be able to make their payments. The resulting legal logistics for recovering the money owed is costly and will cut into the would-be gains.

Final Word

Swaps are a great way for businesses to manage their debt more effectively. The value behind them is based on the fact that debt can be based around either fixed or floating rates. When a business is receiving payments in one form but prefers or requires another, it can engage in a swap with another company that has opposite goals.

Swaps, which are usually conducted between large companies with specific financing requirements, can be beneficial arrangements that work to everyone’s advantage. But they still have important risks to consider before company leaders sign a contract.

Has your company or investment firm ever used an interest rate swap? Did you come out ahead, or were you on the losing side?

Kalen Smith has written for a variety of financial and business sites. He is a weekly contributor for Young Entrepreneur and has worked as a guest blogger on behalf of Consumer Media Network. He holds an MBA in finance from Clark University in Worcester, MA.

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