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- What Are Netting Escrows & How Does It Work?: The Best Guide - January 2, 2024
- The Secret About Prescriptive Easement: Top Guide 1 Must Know - December 4, 2023
- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
What Is an Interest Rate Swap?
A forward contract in which one stream of future interest payments is exchanged for another depending on a specified principal amount is called an interest rate swap.
In an interest rate swap usually, there is an exchange of a fixed interest rate for a floating rate or vice versa, to either reduce or increase the exposure to fluctuations in interest rates or to procure a marginally lower interest rate than would have been possible without the swap.
A basis swap involves the exchange of one type of floating rate for another.
Interest Rate Swaps Explained
When one set of cash flows are exchanged for another then they are Interest rate swaps.
As the trade happens over the counter (OTC), the contracts are between two or more parties according to their desired specifications and can be tailor-made in many different ways.
Swaps are often used if a company can borrow money easily at one type of interest rate but prefers a different type.
Different types of Interest Rate Swaps
The three different types of interest rate swaps are Fixed-to-floating, floating-to-fixed, and float-to-float.
Fixed-to-Floating
If for instance, there is a company that can issue a bond at a very attractive fixed interest rate to its investors.
The company’s management feels that there would be a better cash flow with a floating rate.
Then, in that case, the company can enter into a swap with a counterparty bank in which the company receives a fixed rate and pays a floating rate.
The swap is set out to tone with the maturity and cash flow of the fixed-rate bond, and the two fixed-rate payment streams are netted.
The said company and the bank choose the preferred floating-rate index, which is usually LIBOR for a one-, three-, or six-month maturity.
The company then receives LIBOR plus or minus a layout that reflects both interest rate conditions in the market and its credit rating.
After Dec. 31, 2021, The Intercontinental Exchange, which is the authority responsible for LIBOR, will stop issuing one-week and two-month USD LIBOR.
And after June 30, 2023, all other LIBOR will be discontinued.
Floating-to-Fixed
A company that does not have access to a fixed-rate loan, to achieve a fixed rate may borrow at a floating rate and enter into a swap.
The dates on the loan of floating-rate tenor, reset, and payment is mirrored on the swap and netted.
The company’s borrowing rate is the fixed-rate leg of the swap.
Float-to-Float
To change the type or tenor of the floating rate index that they pay, companies sometimes enter into a swap; this is known as a basis swap.
A company can swap from three-month LIBOR to six-month LIBOR, either because they have a more attractive rate or because it matches other payment flows.
A company can also switch to a different index, like the federal funds rate, commercial paper, or the Treasury bill rate.
Real-World Example of an Interest Rate Swap
To acquire their competitor, if company X needs to raise $75 million. Within the United States, they may be able to borrow the money at a 3.5% interest rate, but perhaps outside of America, they may be able to borrow at just 3.2%.
The hitch being they would need to issue the bond in a foreign currency, which is subject to fluctuation based on the home country’s interest rates.
Company X could for the duration of the bond enter into an interest rate swap. Under the terms of the agreement, company X would pay the issuer a 3.2% interest rate over the life of the bond.
The company then when the bond matures would swap $75 million for the agreed-upon exchange rate and avoid any exposure to exchange-rate fluctuations.
Conclusion
An interest rate swap is a kind of derivative contract through which 2 counterparts agree to exchange one stream of future interest payments for another depending on a specified principal amount.
In order to reduce or increase exposure to fluctuations in interest rates the swaps can be fixed or floating rate.
