Interest Rate Swaps Explained for Dummies (2023)

An interest rate swap is afinancial 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.

(Video) Interest rate swap 1 | Finance & Capital Markets | Khan Academy

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 abond 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.

Interest Rate Swaps Explained for Dummies (1)
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(Video) Interest Rate Swap Explained

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.

(Video) Interest Rate Swaps With 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:

(Video) How swaps work - the basics

  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.

(Video) Swaps / Interest rate swap explained

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?

FAQs

How does a interest rate swap work? ›

How Does an Interest Rate Swap Work? Essentially, an interest rate swap turns the interest on a variable rate loan into a fixed cost. It does so through an exchange of interest payments between the borrower and the lender. The borrower will still pay the variable rate interest payment on the loan each month.

What is swaps in simple words? ›

What Is a Swap? A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything.

How do banks make money on interest rate swaps? ›

The bank's profit is the difference between the higher fixed rate the bank receives from the customer and the lower fixed rate it pays to the market on its hedge. The bank looks in the wholesale swap market to determine what rate it can pay on a swap to hedge itself.

Why do investors use interest rate swaps? ›

Swapping allows companies to revise their debt conditions to take advantage of current or expected future market conditions. Currency and interest rate swaps are used as financial tools to lower the amount needed to service a debt as a result of these advantages.

What are the disadvantages of interest rate swaps? ›

Disadvantages. Hedge funds and other investors use interest rate swaps to speculate. They may increase risk in the markets because they use leverage accounts that only require a small down-payment. They offset the risk of their contract with another derivative.

What are the disadvantages of swap? ›

The disadvantages of swaps are: 1) Early termination of swap before maturity may incur a breakage cost. 2) Lack of liquidity. 3) It is subject to default risk.

What is the purpose of swaps? ›

The objective of a swap is to change one scheme of payments into another one of a different nature, which is more suitable to the needs or objectives of the parties, who could be retail clients, investors, or large companies.

How do you calculate swap rates? ›

Formula to Calculate Swap Rate

It represents that the fixed-rate interest swap, symbolized as a C, equals one minus the present value factor that applies to the last cash flow date of the swap divided by the summation of all the present value factors corresponding to all previous dates.

How do you profit from swaps? ›

The most popular way to profit from swap rates is the Carry Trade. You buy a currency with a high interest rate while selling a currency with a low interest rate, earning on the net interest of the difference.

What are the advantages and disadvantages of swaps? ›

2) Swap can be used to hedge risk, and long time period hedge is possible. 3) It provides flexible and maintains informational advantages.
...
The disadvantages of swaps are:
  • Early termination of swap before maturity may incur a breakage cost.
  • Lack of liquidity.
  • It is subject to default risk.

Is interest rate swap beneficial to the bank? ›

For managing today's costs and planning ahead for the future, an interest rate swap could be advantageous for your organization. While an interest rate swap may seem complex at first, it is a strategy for corporations and lenders alike to manage debt and manage risk more effectively.

Who is the buyer of an interest rate swap? ›

The maturity, or “tenor,” of a fixed-to-floating interest rate swap is usually between one and fifteen years. By conven- tion, a fixed-rate payer is designated as the buyer of the swap, while the floating-rate payer is the seller of the swap.

Is an interest rate swap a hedge? ›

First and foremost, the interest rate swap is a strategy for hedging the risk of unfavorable interest rate fluctuations.

Why do banks buy swaps? ›

Provides competitive advantage - Separating the funding of a loan from the management of interest rate risk through derivatives provides pricing flexibility, usually allowing the bank to be more competitive.

What is interest swap example? ›

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%.

How are interest swaps settled? ›

How Does an Interest Rate Swap Work? Basically, interest rate swaps occur when two parties – one of which is receiving fixed-rate interest payments and the other of which is receiving floating-rate payments – mutually agree that they would prefer the other party's loan arrangement over their own.

How do hedge funds use interest rate swaps? ›

HEDGE FUNDS AND SWAPS

Various types of hedge funds will take down swaps to make directional bets based on movements of interest rates or enter into forward rate agreements to take advantage of perceived pricing or irregularities in the market, all for the purpose of increasing the returns on their managed portfolios.

Is LIBOR a swap rate? ›

In an interest rate swap, it is the fixed interest rate exchanged for a benchmark rate such as LIBOR or the Fed Funds Rate plus or minus a spread. It is also the exchange rate associated with the fixed portion of a currency swap.

What is LIBOR vs SOFR? ›

The main difference between SOFR and LIBOR is how the rates are produced. While LIBOR is based on panel bank input, SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market.

What replaced the Libor rate? ›

The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London Interbank Offered Rate (LIBOR).

How do you calculate interest rate swap? ›

To find the swap rate R, we set the present values of the interest to be paid under each loan equal to each other and solve for R. In other words: The Present Value of interest on the variable rate loan = The Present Value of interest on the fixed rate loan. Solving gives R = 0.05971.

What is a 10 year swap? ›

The “10-year Swap Rate Quotations” means the arithmetic mean of the bid and offered rates for the annual fixed leg (calculated on a 30/360 day count basis) of a fixed-for-floating euro interest rate swap which (i) has a term of 10 years commencing on the first day of the relevant Interest Rate Period, (ii) is in an ...

How do you account for an interest rate swap? ›

First, calculate the difference between the fixed rate the company expects to receive on the swap and the fixed rate it expects to pay on the debt. Second, combine that difference with the variable rate applicable on the swap.

How do interest rate swaps hedge risk? ›

Interest rate swaps

Swaps may be used to hedge against adverse interest rate movements or to achieve a desired balanced between fixed and variable rate debt. Interest rate swaps allow both counterparties to benefit from the interest payment exchange by obtaining better borrowing rates than they are offered by a bank.

Is LIBOR a swap rate? ›

In an interest rate swap, it is the fixed interest rate exchanged for a benchmark rate such as LIBOR or the Fed Funds Rate plus or minus a spread. It is also the exchange rate associated with the fixed portion of a currency swap.

How are swaps calculated? ›

Swap rates can be calculated using the following formula: Rollover rate = (Base currency interest rate – Quote currency interest rate) / (365 x Exchange Rate).

What are the different types of interest rate swaps? ›

There are three different types of interest rate swaps: Fixed-to-floating, floating-to-fixed, and float-to-float.

What is LIBOR vs SOFR? ›

The main difference between SOFR and LIBOR is how the rates are produced. While LIBOR is based on panel bank input, SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market.

What replaced the Libor rate? ›

The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London Interbank Offered Rate (LIBOR).

What is the duration of an interest rate swap? ›

The maturity, or “tenor,” of a fixed-to-floating interest rate swap is usually between one and fifteen years.

Is an interest rate swap a fair value hedge? ›

In the case of an interest rate swap, the hedge may be a cash flow hedge or a fair value hedge. A cash flow hedge is one where the financial institution looks to mitigate risk from variable exposures (such as a swap that effectively hedges LIBOR-based trust preferred securities to a fixed rate).

Is interest rate swap a hedge? ›

First and foremost, the interest rate swap is a strategy for hedging the risk of unfavorable interest rate fluctuations.

How do swap rates affect mortgage rates? ›

As swaps increase, fixed rate mortgages typically rise in price and in doing so, impact affordability negatively. Conversely, if swaps fall, fixed rate mortgages typically follow suit and the affordability and borrowing potential is positively impacted.”

How do you make money when interest rates rise? ›

Here are a few ways to situate your money so that you can benefit from rising rates, and protect yourself from their downside.
  1. Credit cards: Minimize the bite. ...
  2. Home loans: Lock in fixed rates now. ...
  3. Bank savings: Shop around. ...
  4. Another high-yield savings option. ...
  5. Stocks: Seek broad exposure and pricing power. ...
  6. Bonds: Go short.
Jul 27, 2022

How do you protect against rising interest rates? ›

Cut Bond Duration When Interest Rates Are Rising

Topping the to-do list, investors should reduce long-term bond exposure while beefing up their positions in short- and medium-term bonds, which are less sensitive to rate increases than longer-maturity bonds that lock into rising rates for longer time periods.

Are swaps assets or liabilities? ›

Is a Swap an Asset or a Liability? A swap's status as an asset or liability depends on the movement in the payments under the swap. However, Accounting Standards Codification (ASC) 820, "Fair Value Measurement," requires companies to reflect a derivative at fair value in their financial statements.

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