Interest Rate Swap
What Is an Interest Rate Swap?
An interest rate swap is a forward contract where one stream of future interest payments is exchanged for another in light of a predetermined principal amount. Interest rate swaps generally include the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to vacillations in interest rates or to get an imperceptibly lower interest rate than would have been conceivable without the swap.
A swap can likewise include the exchange of one type of floating-rate for another, which is called a basis swap.
Understanding Interest Rate Swaps
Interest rate swaps are the exchange of one set of cash flows for another. Since they trade over-the-counter (OTC), the contracts are between at least two gatherings as per their ideal details and can be altered in a wide range of ways.
Swaps are frequently used in the event that a company can borrow money effectively at one type of interest rate yet favors an alternate type.
Types of Interest Rate Swaps
There are three unique types of interest rate swaps: Fixed-to-floating, floating-to-fixed, and float-to-drift.
Fixed-to-Floating
For instance, consider a company named TSI that can issue a bond at an exceptionally alluring fixed interest rate to its investors. The company's management feels that it can get a better cash flow from a floating rate. In this case, TSI can go into a swap with a counterparty bank in which the company receives a fixed rate and pays a floating rate.
The swap is structured to match the maturity and cash flow of the fixed-rate bond and the two fixed-rate payment streams are gotten. TSI and the bank pick the preferred floating-rate index, which is typically LIBOR for a one-, three-, or half year maturity. TSI then receives LIBOR plus or minus a spread that reflects both interest rate conditions in the market and its credit rating.
The Intercontinental Exchange, the authority responsible for LIBOR, will stop distributing one-week and two-month USD LIBOR after Dec. 31, 2021. Any remaining LIBOR will be discontinued after June 30, 2023.
Floating-to-Fixed
A company that doesn't approach a fixed-rate loan might borrow at a floating rate and go into a swap to accomplish a fixed rate. The floating-rate tenor, reset, and payment dates on the loan are reflected on the swap and got. The fixed-rate leg of the swap turns into the company's borrowing rate.
Float-to-Float
Organizations once in a while go into a swap to change the type or tenor of the floating rate index that they pay; this is known as a basis swap. A company can swap from three-month LIBOR to half year LIBOR, for instance, either on the grounds that the rate is more alluring or it matches other payment flows. A company can likewise switch to an alternate index, for example, the federal funds rate, commercial paper, or the Treasury bill rate.
Certifiable Example of an Interest Rate Swap
Assume that PepsiCo needs to raise $75 million to procure a contender. In the U.S., they might have the option to borrow the money with a 3.5% interest rate, yet outside of the U.S., they might have the option to borrow at just 3.2%. The catch is that they would have to issue the bond in a foreign currency, which is subject to variance in view of the nation of origin's interest rates.
PepsiCo could go into an interest rate swap however long the bond might last. Under the terms of the agreement, PepsiCo would pay the counterparty a 3.2% interest rate over the life of the bond. The company would then swap $75 million for the settled upon exchange rate when the bond develops and keep away from any exposure to exchange-rate vacillations.
Features
- Interest rate swaps are forward contracts where one stream of future interest payments is exchanged for another in view of a predetermined principal amount.
- Interest rate swaps are at times called plain vanilla swaps, since they were the original and frequently the most straightforward such swap instruments.
- Interest rate swaps can exchange fixed or floating rates to reduce or increase exposure to variances in interest rates.
FAQ
What Are Different Types of Interest Rate Swaps?
Fixed-to-floating, floating-to-fixed, and floating-to-floating are the three fundamental types of interest rate swaps. A fixed-to-floating swap includes one company getting a fixed rate, and paying a floating rate since it accepts that a floating rate will generate more grounded cash flow. A floating-to-fixed swap is where a company wishes to receive a fixed rate to hedge interest rate exposure, for instance. In conclusion, a float-to-drift swap — otherwise called a basis swap — is where two gatherings consent to exchange variable interest rates. For instance, a LIBOR rate might be swapped for a T-Bill rate.
What Is an Example of an Interest Rate Swap?
Consider that Company An issued $10 million of every 2-year bonds that have a variable interest rate of the London Interbank Offered Rate (LIBOR) plus 1%. Say that LIBOR is 2%. Since the company is stressed that interest rates might rise, it finds Company B that consents to pay Company A the LIBOR annual rate plus 1% for a long time on the notional principal of $10 million. Company A, in exchange, pays this company a fixed rate of 4% on a notional value of $10 million for a long time. On the off chance that interest rates rise essentially, Company A will benefit. Alternately, Company B will remain to benefit assuming interest rates stay flat or fall.
Why Is It Called "Interest Rate Swap"?
An interest rate swap happens when two gatherings exchange (i.e., swap) future interest payments in light of a predefined principal amount. Among the primary motivations behind why financial institutions use interest rate swaps are to hedge against losses, oversee credit risk, or conjecture. Interest rate swaps are traded on over-the-counter (OTC) markets, intended to suit the requirements of each party, with the most common swap being a fixed exchange rate for a floating rate, otherwise called a "vanilla swap".
