An interest rate swap is a customized contract between two parties to swap two schedules of cash flows. The most common reason to engage in an interest rate swap is to exchange a variable-rate payment for a fixed-rate payment, or vice versa. Thus, a company that has only been able to obtain a floating-rate loan can effectively convert the loan to a fixed-rate loan through an interest rate swap. This approach is especially attractive when a borrower is only able to obtain a fixed-rate loan by paying a premium, but can combine a variable-rate loan and an interest rate swap to achieve a fixed-rate loan at a lower price. A company may want to take the reverse approach and swap its fixed interest payments for floating payments. This situation arises when the treasurer believes that interest rates will decline during the swap period, and wants to take advantage of the lower rates.
The duration of a swap contract could extend for anywhere from one to 25 years, and represents interest payments. Only the interest rate obligations are swapped, not the underlying loans or investments from which the obligations are derived. The counterparties are usually a company and a bank. There are many types of rate swaps; we will confine this discussion to a swap arrangement where one schedule of cash flows is based on a floating interest rate, and the other is based on a fixed interest rate.
For example, a five-year schedule of cash flows based on a fixed interest rate may be swapped for a five-year schedule of cash flows based on a floating interest rate that is tied to the London Interbank Offered Rate (LIBOR).
A swap contract is settled through a multi-step process, which is:
- Calculate the payment obligation of each party, typically once every six months through the life of the swap arrangement.
- Determine the variance between the two amounts.
- The party whose position is improved by the swap arrangement pays the variance to the party whose position is degraded by the swap arrangement.
Thus, a company continues to pay interest to its banker under the original lending agreement, while the company either accepts a payment from the rate swap counterparty, or issues a payment to the counterparty, with the result being that the net amount of interest paid by the company is the amount planned by the business when it entered into the swap agreement.
Several larger banks have active trading groups that routinely deal with interest rate swaps. Most swaps involve sums in the millions of dollars, but some banks are willing to engage in swap arrangements involving amounts of less than $1 million. There is a counterparty risk with interest rate swaps, since one party could fail to make a contractually-mandated payment to the other party. This risk is of particular concern when a swap arrangement covers multiple years, since the financial condition of a counterparty could change dramatically during that time.
If there is general agreement in the marketplace that interest rates are headed in a certain direction, it will be more expensive to obtain a swap that protects against interest rate changes in the anticipated direction.