Interest Rate Swap

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The interest rate swap is an agreement between two parties (where one party is almost always a bank) to exchange interest payments in the same currency over a defined time period, which normally ranges from one to 10 years. One of the parties is paying a fixed rate of interest, while the other is paying a variable rate. The variable interest rate is paid whenever a new coupon is set, which is typically once a quarter. Fixed interest is usually paid at the end of each year.

By engaging in an interest rate swap, a company can shift from fixed to variable payments, or vice versa. Thus, if a company uses a swap to shift from variable to fixed interest payments, it can better forecast its financing costs and avoid increased payments, but loses the chance of reduced interest payments if rates were to decline. If it takes the opposite position and swaps fixed rates for variable rates, then it is essentially betting that it will benefit from a future decline in interest rates. An interest rate swap is especially useful for a company with a weak credit rating, since such entities must pay a premium to obtain fixed-rate debt. They may find it less expensive to obtain variable-rate debt, and then engage in an interest rate swap to secure what is essentially a fixed-rate payment schedule.

The parties to an interest rate swap deal directly with each other, rather than using a standard product that is traded over an exchange. They customarily use the standard master agreement that is maintained by the International Swaps and Derivatives Association. The parties commonly modify a variety of features within the agreement to suit their needs.

The treasurer should arrange for payments under an interest swap agreement to be as closely aligned as possible with the payment terms of the underlying debt agreement. Thus, it is not useful if a counterparty’s payment to the company is scheduled to arrive several weeks after the company is scheduled to pay its bank under a loan agreement. Instead, the counterparty’s payment should be scheduled to arrive just prior to the due date specified in the loan agreement, thereby better aligning the company’s cash flows.

When there is a general consensus that interest rates will increase, a greater volume of market participants will want to lock in their low borrowing rates with fixed interest rates, which tends to force the cost of a swap higher. The reverse situation arises when there is a general consensus that rates will decline; more companies shift into variable-rate debt in expectation of benefiting from lower rates, which makes it less expensive to create a swap for a fixed rate.

If the parties to an interest rate swap agreement choose to terminate it prior to the contractual termination date, they determine the net present value of future payment obligations by each party. They then net the payments together to determine the net incremental payment to be made, which goes to whichever party is disadvantaged by terminating the swap.

There are several risks to be aware of when entering into interest rate swap agreements. They are:

Basis risk. This is caused by the mismatch between the cash flows involved in a swap. For example, the reference rate may be tied to LIBOR, while the interest rate on a company’s borrowing may be tied to some other index, such as an index of money market funds. Thus, if LIBOR increased by 0.5% and the basis for a company’s debt increased by 0.6%, then the payments it receives through a swap arrangement would still leave the company with an unhedged 0.1% interest rate increase.
Counterparty risk. One of the parties to a swap agreement may not meet its financial obligations. Accordingly, it is important for the counterparty to have excellent credit quality. If a bank or broker is acting as the intermediary between two parties, then it may assume the counterparty risk by charging a fee to both parties to the swap.
Legal risk. One of the parties to an over-the-counter transaction may have incorrectly or incompletely filled out a contract, or the signer of it may not have been authorized to do so.