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Interest rate swaps are contracts in which two counter parties agree to swap periodic interest payments, usually for a fixed time period. Also known as ‘vanilla swaps,’ these contracts are the most basic and commonly-traded type of interest rate swaps. Companies use interest rate swaps to hedge against changes in interest rates (by fixing their borrowing costs), speculation/trading on future interest rate movements, or both.
An interest rate swap involves an exchange of a floating rate for a fixed rate, or vice versa, to take advantage of differentials in interest rates. Companies use swaps when they want to convert their variable-rate debt to a fixed rate or lock in a lower interest rate.
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In a fixed-to-floating swap, one party agrees to make payments based on a fixed interest rate (typically the ‘borrower’), while the other pays on a floating interest rate (typically the ‘hedge counterparty’). In the UK, the floating rate is usually based on Sterling Overnight Index Average (SONIA), which replaced the London Interbank Offered Rate (LIBOR), also known as a ‘benchmark rate.’ Companies use this type of swap when they want to exchange the risk of rising interest rates for the certainty of a fixed rate.
For example, consider a company named RCG that has borrowed at a floating interest rate. The company expects interest rates to rise, so it enters a fixed-to-floating swap agreement with another party, swapping its floating-rate payments for fixed-rate payments. If interest rates do indeed increase, RCG saves money by paying the fixed rate set in the contract instead of the higher floating rate.
A floating-to-fixed swap is the opposite of a fixed-to-floating swap. In this type of swap, one party agrees to make payments on a floating interest rate while the other pays at a fixed interest rate. Companies that can’t issue bonds at a floating interest rate often enter floating-to-fixed swaps to mimic a bond issued with a floating reference.
For example, consider a company issuing a bond referencing a fixed interest rate. ABC can enter a floating-to-fixed interest rate swap with a hedge counterparty, typically a commercial or investment bank, where it pays the fixed rate and receives payments referencing the floating rate.
In float-to-float, companies trade periodic payments on two different floating interest rates, also called a ‘basis swap.’ The most common form of this swap is the 6-month EURIBOR for 1 or 3-month EURIBOR, which changes the interest payments from every six months to either one or three months. This can be useful for companies that want to change their payment schedule without amending their existing swap or loan agreement.
For example, if a company finds that the 3-month rate is more attractive than its current 6-month EURIBOR swap rate, it might enter into a basis swap. Rather than terminating its old trade and starting a new one, the company enters into a float-to-float swap and can benefit from favourable market conditions.
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To manage the floating interest rate risk brought about by borrowing money from banks, public markets or debt funds, companies enter into interest rate swaps. Interest rate swaps help manage risk by fixing the borrowing cost for a period.
Banks and financial institutions process huge transactions, including loans, bonds, and other assets. Interest rate swaps help reduce the risk of fluctuating interest rates for such transactions.
For example, if a bank issues a loan at a floating interest rate and the rate rises and the borrower has entered a swap where it pays a fixed rate and receives a floating rate, then the risk to the bank is also reduced, as the borrower is not affected by the increase in interest rates. Interest rate swaps therefore help by managing risk for both the borrower and the hedge counterparty.
If a company takes out a fixed-rate loan, it’s stuck with the fixed interest rate for the life of the loan. Interest rate swaps, though, can offer flexibility or customization to suit the company’s needs. For example, a company might want to swap from a fixed interest rate to a floating one after two years. This change allows the company to take advantage of lower interest rates without refinancing the entire loan and incurring additional fees.
Interest rate swaps can help companies adjust their exposure to interest rates and manage their volatility. Interest rate swaps can help companies adjust their exposure to interest rates and manage their volatility. To maximise profits, you can use interest rate swaps to speculate on the future direction of rates. This swap can also offer comfort to those concerned about future interest rate changes and allow them to reduce the cost of debt if they expect rates to rise.
Trading involves trying to predict the future direction of interest rates and enter a swap accordingly for economic gain. Some investors use interest rate swaps to speculate on the future direction of interest rates by entering a swap agreement and then selling it before it matures. While this can lead to gain, it comes with significant risks and may have unlimited downsides.
Hedging is the act of limiting risks through investment. Interest rate swaps can be used to protect against the risk of rising or falling interest rates, depending on the exposure the company has. Interest rate swaps can hedge against the risk of interest rate changes on a loan, bond, or other assets by offsetting the changes in value when structured well.
When companies plan to issue fixed-rate bonds or enter into a swap in the future, they can use interest rate swaps to protect themselves from the risk of rising interest rates before putting a hedge in place. This can give certainty about future interest rates early on. However, these companies would need to understand the associated risks.
When you enter a swap agreement, you agree to exchange payments with another party. There’s always the risk that the other party may default on the contract. Only enter swap agreements with reputable financial institutions to protect yourself from this risk.
Interest rate swaps trade in the market, so the value of the trade can change all the time. If rates move against you, the value of your swap will decrease. You can manage this risk by setting up a collateral agreement, where the two parties agree to post collateral if the value of the swap changes.
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Interest rate swaps can protect you from the risk of rising or falling interest rates. They’re a valuable tool for hedging against interest rate risk on a loan, bond, or other assets.
Overall, interest rate swaps are a versatile financial instrument with many uses. It’s important to understand the risks before entering any swap agreement. But if you manage the risks, swaps can be a valuable tool for hedging, trading, and pre-hedging.
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