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 usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally 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 in which one stream of future interest payments is exchanged for another based on a specified principal amount.
- Interest rate swaps can exchange fixed or floating rates to reduce or increase exposure to fluctuations in interest rates.
- Interest rate swaps are sometimes called plain vanilla swaps, since they were the original and often the simplest such swap instruments.
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Understanding Interest Rate Swaps
Interest rate swaps are the exchange of one set of cash flows for another. Because they trade over the counter (OTC), the contracts are between two or more parties according to their desired specifications and can be customized in many different ways.
Swaps are often utilized if a company can borrow money easily at one type of interest rate but prefers a different type.
Types of Interest Rate Swaps
There are three different types of interest rate swaps: Fixed-to-floating, floating-to-fixed, and float-to-float.
Fixed-to-Floating
For example, consider a company named TSI that can issue a bond at a very attractive fixed interest rate to its investors. The company’s management feels that it can get a better cash flow from a floating rate. In this case, TSI can enter into a swap with a counterparty bank in which the company 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, and the two fixed-rate payment streams are netted. TSI and the bank choose the preferred floating-rate index, which is usually the London Interbank Offered Rate (LIBOR) for a one-, three-, or six-month maturity. TSI then receives the LIBOR plus or minus a spread that reflects both interest rate conditions in the market and its credit rating.
The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one-week and two-month USD LIBOR after Dec. 31, 2021. All other LIBOR were discontinued after June 30, 2023.
Floating-to-Fixed
A company that does not have access to a fixed-rate loan may borrow at a floating rate and enter into a swap to achieve a fixed rate. The floating-rate tenor, reset, and payment dates on the loan are mirrored on the swap and netted. The fixed-rate leg of the swap becomes the company’s borrowing rate.
Float-to-Float
Companies sometimes enter into a swap to change the type or tenor of the floating rate index that they pay; this is known as a basis swap. A company can swap from three-month LIBOR to six-month LIBOR, for example, because the rate either is more attractive or matches other payment flows. A company can also switch to a different index, such as the federal funds rate, commercial paper, or the Treasury bill rate.
Real-World Example of an Interest Rate Swap
Suppose that PepsiCo needs to raise $75 million to acquire a competitor. In the United States, they may be able to borrow the money with a 3.5% interest rate, but outside of the U.S., they may be able to borrow at just 3.2%. The catch is that they would need to issue the bond in a foreign currency, which is subject to fluctuation based on the home country’s interest rates.
PepsiCo could enter into an interest rate swap for the duration of the bond. Under the terms of the agreement, PepsiCo would pay the counterparty a 3.2% interest rate over the life of the bond. The company would then swap $75 million for the agreed-upon exchange rate when the bond matures and avoid any exposure to exchange-rate fluctuations.
Why is it called ‘interest rate swap’?
An interest rate swap occurs when two parties exchange (i.e., swap) future interest payments based on a specified principal amount. Among the primary reasons why financial institutions use interest rate swaps are to hedge against losses, manage credit risk, or speculate. Interest rate swaps are traded on over-the-counter (OTC) markets, designed to suit the needs of each party, with the most common swap being a fixed exchange rate for a floating rate, also known as a vanilla swap.
What is an example of an interest rate swap?
Consider that Company A issued $10 million in two-year bonds that have a variable interest rate of the London Interbank Offered Rate (LIBOR) plus 1%. Say that LIBOR is 2%. Since the company is worried that interest rates may rise, it finds Company B that agrees to pay Company A the LIBOR annual rate plus 1% for two years on the notional principal of $10 million. In exchange, Company A pays Company B a fixed rate of 4% on a notional value of $10 million for two years. If interest rates rise significantly, Company A will benefit. Conversely, Company B will stand to benefit if interest rates stay flat or fall.
What are different types of interest rate swaps?
Fixed-to-floating, floating-to-fixed, and float-to-float are the three main types of interest rate swaps. A fixed-to-floating swap involves one company receiving a fixed rate and paying a floating rate since it believes that a floating rate will generate stronger cash flow. An example of a floating-to-fixed swap is where a company wishes to receive a fixed rate to hedge interest rate exposure. Lastly, a float-to-float swap—also known as a basis swap—is where two parties agree to exchange variable interest rates. For example, a LIBOR may be swapped for a Treasury bill (T-bill) rate.
The Bottom Line
An interest rate swap is an agreement between different parties to exchange one stream of interest payments for another over a specified time period. They are derivative contracts that trade over the counter (OTC) and can be customized by the participating parties to match their needs.
Usually, interest rate swaps exchange fixed-rate payments for floating-rate payments, or the other way around, and are used to manage exposure to fluctuating interest rates or to get a lower borrowing rate.
