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Interest Rate Swap

What is an Interest Rate Swap?

An Interest Rate Swap is a forward contract between two counterparties, the Borrower and the Bank, to exchange future interest payments based on a pre-agreed amount. The Borrower agrees to exchange a fixed rate of interest for a floating rate or the other way around, to reduce exposure to interest rate fluctuations or to secure a better rate. The structure of the Swap matches the maturity and cash flow of the original loan. The preferred floating benchmark rate is usually LIBOR with a specific tenor. The floating benchmark rates cancel each other out leaving the Borrower paying only a fixed Swap rate plus a margin.

Figure A:

The floating benchmark rate (LIBOR) cancels each other out leaving the Borrower paying only a fixed swap rate plus a margin.

Objectives

For the Borrower, the purpose of the Swap is to fix the cost of finance and protect them from negative changes in interest rates.

How does it work?

The Borrower enters into a contract with the counterparty to exchange a floating rate of interest for a fixed rate of interest. If the floating rate is set above the fixed rate at the beginning of a three-month period, the Bank will make a net payment to the Borrower equal to the difference between the fixed and floating rate. If it is below, the Borrower will make a net payment to the Bank. The result is that the cost of funds will remain the same no matter where the floating rate sits.

Advantages
  • The Borrower benefits from a pre-agreed rate of interest and certainty of cash flow.
  • No upfront premium is payable.
Disadvantages
  • The Borrower cannot benefit if the floating rate drops below the fixed rate at any time during the term of the contract.
  • Early termination costs are rate sensitive and may be unpalatable if the prevailing market interest rates at the time of termination are significantly below the fixed rate of the swap for the remaining term.
Interest Rate Swap example

 

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