What is an interest rate swap?

In finance, an interest rate swap refers to a type of derivative contract, in which two parties agree to exchange one stream of forthcoming interest payments for another, over a set period based on a defined principal amount. The value of the interest rate swap is determined by the underlying value of the two streams of interest payments. The majority of swaps are based on bonds that have variable-rate interest payments that change over time.

There are three primary types of interest rate swaps: fixed-to-floating, floating-to-fixed and float-to-float interest rate swaps. More frequently, interest rate swaps involve the exchange of a floating interest rate for a fixed rate, or vice versa. This is typically done in order to speculate on fluctuations in interest rates or to hedge against the possible declines in the interest rate returns.

Where have you heard about interest rate swaps?

You may have heard about the term from the Financial Times and other financial news sources when interest rate swaps are used by large companies, financial institutions and sometimes public authorities.

Commonly, commercial and investment banks with strong credit ratings are the driving force of the interest rate swap market, offering both floating and fixed-rate cash flows to their clients. The parties involved in a typical interest rate swap transaction are an investment or commercial bank on one side and a company or an investor on the other side.

What you need to know about interest rate swaps...

Interest rate swaps are only traded over the counter, or OTC. Like other types of OTC instruments, they can be customised and structured in many ways to meet the specific needs of the counterparties. Every market participant has his own requirements and priorities, and interest rate swaps can work to the advantage of both parties.

Interest rate swaps give investors the opportunity to offset the risk of changes in future interest rates or to profit from their potential increase.

As we have already mentioned, an interest rate swap typically involves two parties exchanging one stream of future payments, which are based on a fixed interest rate, for another stream of future payments, which are based on a floating interest rate.

A fixed interest rate means that the interest rate on a security stays unchanged during the term of the contract or until the maturity of the security. Contrarily, a floating interest rate is not locked and can fluctuate over time. These changes in the interest rate are often based on an underlying benchmark index.

The London Inter-bank Offered Rate, or LIBOR, is an interest-rate average that the leading banks in London charge each other for short-term loans. It is commonly used as a benchmark for measuring other interest rates that lenders charge for different types of financing.

In an interest rate swap, the counterparties do not take ownership of each other’s debts. Instead, they only exchange the interest payments, paying each other the difference in loan payments as agreed in the contract.

A well-made interest rate swap contract must state clear terms of the agreement, such as the payment schedule and the respective interest rates each side is to be paid by another. Additionally, the contract should include both the start and maturity dates of the swap agreement, binding both  sides by the terms of the agreement throughout its validity.

In a scenario where interest rates rise during the term of the swap contract, the side that receives the floating rate will profit and the side that receives the fixed rate will suffer a loss. If the opposite happens and interest rates fall, gains and losses between the parties will be reversed the other way around.

Let us see how it works in this example...

Imagine there are two investors: Mary and John. Mary holds the note on a loan worth $100,000 that pays a fixed 2.5 per cent monthly interest rate. John also holds the note on a $100,000 loan, but with a floating interest rate that pays the LIBOR monthly rate plus 0.5 per cent.

Mary believes that interest rates are likely to increase within a few years. She wants to try to profit from a floating interest rate return that would grow if interest rates rise. John, on the other hand, is more sceptical. He thinks that interest rates are more likely to fall during the next two years, diminishing their interest rate return. He wants to protect himself from falling rates by receiving a fixed rate return predefined for the period.

Both investors agree on a two-year interest rate swap, with a nominal value of $100,000. Mary offers John a fixed rate of 2.5 per cent in exchange for getting a floating rate of the LIBOR rate plus 0.5 per cent. The swap agreement states that interest payments must be made annually, and that the floating rate for John should be calculated using the prevailing LIBOR rate at the time that interest payments should be made.

At the beginning of the contract, the current LIBOR rate is 2 per cent. Therefore, when entering the deal, both parties are equal, receiving 2.5 per cent.

Let us assume that by the end of the first year of the contract interest rates rise and the LIBOR rate increases to 2.25 per cent.

In this situation, Mary owes John the fixed rate return of $2,500 (2,5 per cent of $100,000). However, as interest rates have increased indicated by the LIBOR, John owes Mary $2,750 (2.25 per cent + 0.5 per cent = 2.75 per cent of $100,000). In this case, Mary would receive $250 difference from John.

Mary has profited from accepting the additional risk that comes with a floating interest rate. Meanwhile, John has suffered a loss of $250. However, he has still received what he wanted: protection from a possible interest rate decline.