What is Interest Rate Swaps? Understand Here!

5 mins read

Introduction

If you are looking to fund the start of your new company, are looking to expand your customer base or grow your production capacity, chances are that you will likely look into acquiring debt to fund your short-term expenses. The hope here is that the revenue you earn in the long term will help you cover the interest payments of the debt, while still being able to net a profit at the end of the financial year. This interest rate which you pay on your debt comes in two forms and forms the basis for what is known as interest rate swaps. In this article, we will break down what interest rate swaps are (interest rate swaps meaning) and provide an in-depth explanation of the mechanics of interest rate swaps through an interest rate example.

Before we dive into what interest rate swaps are, we must first visit that interest rate mentioned earlier. Interest rates come in two forms, and understanding how the two types of interest rates function are essential to understanding not only how an interest rate swap works, but also why companies would want to deal in interest rate swaps in the first place.

Fixed Interest Rate vs Floating Interest Rate

This concept is fairly simple to grasp, yet plays an essential role in the understanding of interest rate swaps. It will also be useful for the interest rate swap example we have planned.

Fixed Interest Rate: A fixed interest rate implies that the borrower will pay a fixed sum for every period (monthly, annually etc), until the loan lapses. If for instance, you borrow USD 1 Million at a fixed interest rate of 8%, you will have to pay USD 80,000 every year, until the loan period ends.

Floating Interest Rate: As the name suggests, a floating interest rate is not constant, and usually varies based on the value of an underlying benchmark index. Labour is a common benchmark index( LIBOR or the London Interbank Offered Rate, is an interest rate average that is calculated based on estimates submitted by a slew of top banks in London. Labour is simply a popular example, and the interest rate terms can theoretically be based on any underlying benchmark index of choice, provided both parties agree to it, as do regulators). If you were to borrow the same USD 1 million, with a floating exchange rate you would pay interest based on certain terms. For instance, if Libor is 5%, the terms of the loan would dictate you pay Libor + 2%, or USD  70,000. If in the second period Libor is at 4%, you might pay Libor + 2%, or usd 60,000. These numbers will be useful for our example.

How Interest rate swaps work

Cutting through the jargon, an interest rate swap takes place when two entities are not happy with their current interest payment setup and wish to switch from a floating to fixed interest rate, or vice versa, in hopes that the market will move in their favour.

Let’s say company A borrows USD 1 million dollars from Lender A, at a floating interest rate of Libor + 2%. This means that if in Period 1 Libor was 5%, Company A pays 5% + 2%, or USD 70,000 dollars on the million-dollar loan. If Libor is at 4% the next period, this moves to USD 60,000 accordingly.

Company B takes out a loan from Lender B at a fixed interest rate of 8%. Meaning for period 1 and 2, they will pay 8% or 80,000 dollars. For the sake of this example, let’s assume that both Company A and B wish to swap their interest rate payments. This is how they would go about it.

As per the terms of their Interest rate swap agreement, Company A agrees to pay Company B 7% (of the notional one million) per period. In return, Company B will pay Company A Libor + 1% per period.

Period Company A Company B
1 (With Libor at 5%) Pays –70,000 dollars to B Pays Libor + 1% (-60,000) to Company A
Pays Libor + 2% (-70,000)  to Lender A Pays -80,000 dollars to Lender B
Gets Libor + 1% (+60,000) from Company B Gets +70,000 from Company A.
Total Interest Paid for Period 1 80,000 70,000
   
2 (With Libor at 4%) Pays -70,000 dollars to Company B Pays Libor + 1% (-50,000) to company A
Pays Libor + 2% (-60,000) to Lender A Pays -80,000 dollars to Lender B
Gets Libor + 1% (+50,000 dollars) from company B Gets +70,000 dollars from company A.
Total Interest Paid for Period 1 80,000 60,000

*ALL values are positive. The “-” and “+” signs signify credit (+) and debit (-) moves.

As you can see on the chart (look at the Total Interest Paid by both companies for both periods), the interest rate swaps have resulted in company A now having a fixed interest rate payment, while company B which had the fixed interest payment, now has a floating interest rate setup. The swap has granted both entities their desired debt repayment structures.

Things to keep in mind

The keen-eyed among you might have noticed us mention that the payment in the example was offered on the “notional” one million. This is because, in an interest rate swap, no debt actually exchanges hands, simply the difference between the debt payment does. In the example mentioned above, neither company takes on the responsibility of each other’s debt or the debt amount. They simply enter into an agreement that is tethered to their individual loan agreements, resulting in them being able to switch their repayment structures.

Additionally, in this setup, one company stands to win while the other stands to lose; there can be only one winner. If Libor goes up, company B might have the raw end of the deal. If it goes down, however, it gets to make lower debt payments. Lastly, interest rate swaps cannot be traded on any official stock exchange, they exist exclusively in the OTC (over-the-counter) markets.