What Is an Interest Rate Swap?
An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps typically involve the exchange of a fixed interest rate for a floating rate, or vice versa, to manage exposure to fluctuations in interest rates or to obtain a potentially lower interest rate than would have been possible without the swap.
A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap.
Key Takeaways
- Interest rate swaps are forward contracts where one stream of future interest payments is exchanged for another based on a specified principal amount.
- They can exchange fixed or floating rates to manage exposure to interest rate fluctuations.
- Often termed as plain vanilla swaps, interest rate swaps are one of the simplest swap instruments.
Understanding Interest Rate Swaps
Interest rate swaps involve the exchange of one set of cash flows for another. Conducted over-the-counter (OTC), these contracts are customized between two or more parties based on their desired specifications.
Swaps are commonly utilized by companies that can borrow money easily at one type of interest rate but prefer a different type for their financial strategies.
Types of Interest Rate Swaps
Here are the three main types of interest rate swaps:
Fixed-to-Floating
A company that can issue a bond at a favorable fixed interest rate to its investors may believe it can achieve better cash flow with a floating rate. In this scenario, the company enters into a swap with a counterparty bank where it 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, choosing a preferred floating-rate index like the London Interbank Offered Rate (LIBOR). The company then receives the LIBOR rate plus or minus a market-based spread.
Floating-to-Fixed
A company without access to a fixed-rate loan might borrow at a floating rate and engage in a swap to achieve a fixed rate. The swap reflects the same tenor, reset, and payment dates as the loan, converting the floating to a fixed borrowing rate through the fixed leg of the swap.
Float-to-Float
This swap, also known as a basis swap, involves exchanging one floating rate for another. It’s beneficial if one rate appears more favorable or aligns better with other financial commitments. Companies might switch from three-month LIBOR to six-month LIBOR or opt for different indices like the federal funds rate or Treasury bill rate.
Real-World Example of an Interest Rate Swap
Consider PepsiCo needing to raise $75 million for a competitor acquisition. Borrowing in the United States might incur a 3.5% interest rate, compared to a lower 3.2% rate internationally, although the latter involves foreign currency exposure. To mitigate this, PepsiCo could enter an interest rate swap, paying 3.2% over the bond’s life, and exchange $75 million at maturity, avoiding currency fluctuation risks.
Why is it Called ‘Interest Rate Swap’?
An interest rate swap occurs when two parties exchange future interest payments based on a specified principal amount. Primary reasons for financial institutions to use swaps include hedging against losses, managing credit risk, or engaging in speculation. Traded OTC, interest rate swaps are customized to suit the needs of the parties involved, with the fixed for floating rate swap being the most common.
Example of an Interest Rate Swap
Let’s say Company A issued $10 million in two-year bonds with a variable rate of LIBOR plus 1%, and LIBOR is 2%. To mitigate rising rates, Company A finds Company B which agrees to pay LIBOR plus 1% annually on the $10 million notional principal, in return for a 4% fixed rate from Company A for two years. This hedge benefits Company A if rates rise, while Company B prevails if rates fall or stay flat.
Different Types of Interest Rate Swaps
The three core types of swaps are:
- Fixed-to-Floating: One party receives a fixed rate and pays a floating rate, often seeking better cash flow.
- Floating-to-Fixed: The party receives a fixed rate to mitigate interest rate exposure.
- Float-to-Float: Parties exchange variable rates to capitalize on favorable indices, such as swapping LIBOR for a Treasury bill rate.
The Bottom Line
Interest rate swaps are agreements to exchange streams of interest payments over a specified period. As derivative contracts, they are traded OTC and can be tailored to the needs of the parties involved. They typically involve exchanging fixed-rate payments for floating-rate ones or vice versa, to manage interest rate risk or achieve a lower borrowing rate.
References
- Jennifer N. Carpenter, NYU Leonard N. Stern School of Business. “Interest Rate Swaps Slides”. Page 2.
- PIMCO. “Understanding Investing: Interest Rate Swaps”.
- Commodity Futures Trading Commission. “CFTC Swaps Report Data Dictionary”. Page 2.
- Intercontinental Exchange. “LIBOR®”.
