INTEREST RATE SWAPS
In terms of swaps, the market offers different opportunities for the hedging of future interest rate changes. Some of them are pure interest rate transactions but some of them are currency transaction or a mix of interest rate and currency.
Interest rate swaps are defined as the agreements between two parties to exchange interest payments on an agreed national amount for a particular maturity. The important point is that it is a notional amount, so the principal is not exchanged. The exchange of interest payments may be;
Swaps can be useful for locking in a fall in the interest rate. Interest rate swaps are basically used as a long-term instrument for periods more than one year. It is similar to
forward rate agreements (FRAs) but like a series of FRAs, one for each payment date.Table 17 involves five examples. These transactions can be summarised as follows;
Major Kinds of Interest Rate Swaps
Firm 1 borrows at |
Firm 2 borrows at |
Currency denomination |
Currency swaps 1. Fixed interest (CHF) 2. Floating interest (CHF) |
Fixed interest ($) Floating interest ($) |
Different Different |
Interest rate swaps 3. Fixed interest 4. Floating interest |
Floating interest Floating interest |
Same Same |
Currency and interest rate swaps 5. Fixed interest(CHF) |
Floating interest($) |
Different |
Source: Oxelheim and Wihlborg (1987)
The most used swap is the third one which one party pays a floating rate and the other party pays a fixed rate. Although about 75% of swaps are indexed to LIBOR, other typical floating rate indices are commercial paper funds rate, the prime rate and the T-bill rate.
The benefit of cost saving can be illustrated by the following example for the most popular fixed-floating interest rate swap:
Direct Funding
Credit Rating |
Company A |
Company B |
Interest Differential |
Direct Funding Availability- Fixed Rate Funds |
8% p.a. |
9.50% p.a. |
1.50% p.a. |
Floating Rate Funds |
6 month LIBOR+¼% |
6 month LIBOR+¾% |
0.50% p.a. |
Company A raises Fixed Rate Funds |
(8% p.a.) |
|
|
Company B raises Floating Rate Funds |
|
(6 month LIBOR+¾) |
|
Source: Greenacre (1992)
Company B must make floating rate funds available to Company A at a cheaper rate than that at which Company A could borrow in its own name, which is LIBOR+¼%. Therefore, in the swap Company B must make the floating rate funds available to Company A at LIBOR and must continue, itself, to pay the mark-up of ¾% p.a. This makes the effective cost of Company B’s fixed rate funds 9% p.a. i.e. 8.25% plus 0.75%.
Swaps Structure
|
Company A |
Company B |
Company A “Lends” to Company B-Fixed Rate |
8.25% p.a. |
(8.25% p.a.) |
Company B “Lends” to Company A-Floating Rate |
(LIBOR) |
LIBOR |
Net Funding Cost Company A (Floating) X |
LIBOR-¼% |
|
Company B (Fixed) X |
|
9% p.a. (8.25%+¾%) |
Direct Funding Cost Y |
LIBOR+¼% |
9.50 |
Comparison- Saving (Y-X) |
0.50% p.a. |
0.50% p.a. |
Source: Greenacre (1992)