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What is Interest Rate Swap?
An interest rate swap (IRS) is a type of derivative contract where the two counterparties agree to exchange one stream of future interest payments for another based on the specific principal amount. Generally, these contracts involve the exchange of a fixed interest rate for a floating interest rate or vice versa. This helps to reduce the exposure to interest rate fluctuations or obtain a marginally lower interest rate with the help of a swap. Moreover, interest rate swaps are also called plain vanilla swaps.
These contracts are traded over the counter (OTC), which can be customised in different ways according to the parties’ desired specifications.
Read more about Fixed vs Floating Interest Rate
How Do Interest Rate Swaps Work?
The interest rate swap occurs between two parties, where they exchange a series of interest payments. One party receives fixed-rate payments, and the other receives floating-rate payments. The party enters into a contract with the expectation that the interest rate may rise or fall and which situation could benefit them. They create a customized agreement that includes the frequency of payments, loan tenure, and principal amount. The principal amount is the notional amount, which remains the same in the contract. The only thing that gets swapped is the interest rate.
Under this contract, one party may reap the financial reward while another may incur a financial loss. If interest rates rise, the party receiving the floating rate will profit, and the party receiving the fixed rate will incur a loss. In contrast, if the interest rate falls, the party getting paid the fixed return will benefit, while the party receiving the floating rate will see that the interest payments will go down.
Example
For instance, party A has an investment of INR 10 lakhs for 3 years with an interest rate of 7%. Party B has an investment with an interest rate of MIBOR (currently 6%) +1% on INR 10 lakhs for 3 years. Both parties receive the same amount monthly as long as MIBOR is 6%. However, party A believes that rates will rise and would want a floating rate. In contrast, party B assumes that rates are falling and would want a fixed rate.
The two parties enter into an interest rate swap agreement in which party B will make monthly payments to party A of MIBOR+1% on the notional principal amount of INR 10 lakhs for 3 years. At the same time, party A will make monthly payments to party B of 7% every month on the same notional amount for 3 years. This is a standard interest rate swap, where the notional principal amount of INR 10 lakhs remains the same.
Assume that in the following month, the MIBOR rises to 6.5%. In this case, party B will receive a fixed payment of 7%. However, party A will receive the new MIBOR +1%, i.e. 7.5% on the principal amount. This way, party A will benefit if the interest rate rises.
Types of Interest Rate Swaps
There are three different types of interest rate swaps –
Fixed to Floating
Under this type of swap, the party enters into an agreement that receives cash flow through a fixed interest rate but pays out a floating interest rate. The interest amount is based on the notional principal amount. Moreover, the floating rates are referenced through the MIBOR benchmark, which is set daily.
For instance, a company can issue its investors a bond at an attractive fixed interest rate. Later, the company feels it can get better cash flow from a floating interest rate. Thus, the company enters into a swap with a counterparty bank where the company receives a fixed rate and pays a floating interest rate.
*MIBOR – The Mumbai Inter-Bank Offered rate is the overnight lending offered rate for Indian commercial banks. It is the benchmark interest rate at which bonds borrow funds from other Indian banks. Also, it is calculated based on the input panel of 30 banks and primary dealers. MIBOR is modelled from the famous London Inter-Bank Offered Rate (LIBOR).
Floating to Fixed
Under this type of swap, the party enters into an agreement that receives cash flow through a floating interest rate but pays out a fixed interest rate. Also, the interest is calculated based on the principal amount.
For instance, 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 the fixed rate. The contract specifications like tenor, frequency and dates of floating rate are mirrored on the swap contract. Thus, the fixed rate becomes the company’s borrowing rate.
Float to Float
Under this type of swap, companies enter into an agreement to change the type or tenor of the floating rate index to get attractive rates. In other words, the companies exchange receipts on a specific principal amount based on floating rates referenced at two separate benchmarks. This is also known as a basis swap.
For instance, a company may sway from a three-month MIBOR to a six-month MIBOR either because the rate is attractive or it matches other payment flows. Also, the company may switch to a different index like government bonds rate, treasury bill rate, etc.
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Advantages and Risks of Interest Rate Swaps
The following are the advantages of interest rate swaps –
- Hedging Risk: The significant advantage of these swaps is minimizing the interest rate risks. By swapping, the parties can make profitable deals while making optimal cash flows per their requirements.
- Comparative Advantage: Sometimes, companies can receive an interest rate better than the borrower rate. However, this is different from the financing that the companies look for. For instance, a company may want to swap the floating interest with a fixed interest rate from another company which can fulfil their requirements.
The following are the risks of interest rate swaps –
- Interest Rate Risk: The movement of interest rates is unpredictable, which can add inherent risk to both parties in the agreement. It means that the receiver will profit only if the floating interest rate falls, while the payer will profit only if the floating interest rate increases.
- Credit Risk: These contracts are generally prone to the credit risk of the counterparty. This happens when one party in the contract tends to default and won’t be able to make the payments. It becomes difficult for the other party to collect.
Frequently Asked Questions
A swap rate is a fixed interest rate that a receiver demands in exchange for the uncertainty of paying short-term MIBOR floating rates. At the time of entering the swap agreement, the fixed rate remains equal to the floating rate payment as calculated by the forward MIBOR curve. Also, swap rates are quoted as fixed rates or swap spread, which calculates the difference between the swap rate and the government bond yield with a similar maturity.
A swap curve shows the relationship between the swap rates at various maturities. Knowing the swap curve while understanding the interest rate benchmark is essential. Generally, the swap curve and the sovereign yield curve are in a similar shape, and they can trade either higher or lower than the sovereign yield. Thus, the difference between the two is the swap spread.
Interest rate swaps are derivative contracts that have become an integral part of fixed-income markets. These contracts exchange or swap fixed interest payments for floating interest payments. Also, it is an essential tool for investors as they can use them to hedge, speculate and manage risk.
Explore: What is Fund Flow Statement?
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