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:: Interest Rate Swaps ::

An Interest Rate Swap is a private agreement between two parties to exchange one stream of cash flow for another stream of cash flow on a specific amount of principal for a specific period of time. Investors use swaps to exchange fixed-rate liabilities/assets into floating rate liabilities/assets and vice versa.

For example, consider Company A with £50,000,000 of floating-rate debt outstanding on which it is paying LIBOR plus 150 bps (basis points), i.e. if LIBOR is 4%, the interest rate would be 5.5%. The company thinks that interest rates will rise, i.e. company's interest expense will rise, and the company decides to convert its debt from floating-rate into fixed-rate debt.

Now consider Company B which has £50,000,000 of fixed-rate 6% debt. The company thinks that interest rates will fall, which would benefit the company if it has floating-rate debt instead of fixed-rate debt, since its interest expense will reduce. By entering into an interest rate swap with Company A, both counterparties can effectively convert their existing liabilities into the ones they truly want.

In this swap, Company A might agree to pay Company B fixed-rate interest payments of 5% and Company B might agree to pay Company A a floating-rate interest payments of LIBOR. Therefore Company A will pay LIBOR + 150 to its original lender and 5% in the swap, giving a total of LIBOR + 6.5%, it receives LIBOR in the swap. This leaves an all-in cost of funds of 6.5%, a fixed rate. In the case of Company B, it pays 6% to its original lender and LIBOR in the swap, giving a total of LIBOR + 6%. In return it receives 5% in the swap, leaving an all-in cost of LIBOR + 1%, a floating rate.

Applications of Swaps

The interest rate swap market is driven by the differences in the credit quality between entities borrowing money. Some corporations may have a better borrowing profile in short maturities than they do in long maturities. Others with more creditworthy status have an advantage raising money with longer maturities. Therefore in fixed-floating interest rate swaps, the corporation paying fixed and receiving floating is usually the less creditworthy of the two counterparties.

Interest rate swaps give the less creditworthy entity a way of borrowing fixed rate debts for a longer term at cheaper rates than they could in the capital markets by taking advantage of its relative strength in raising funds with shorter maturities.

Consider two companies C and D with credit ratings of AA and BBB+ respectively. The 3-year fixed interest rates for AA and BBB+-rated companies are 6% and 7% respectively. The 3-year floating interest rates these two companies are LIBOR + 10 (bp) and LIBOR + 60 respectively. Higher credit rating means lower borrowing rates.

The AA-rated Company C is able to save 50 bp relative to BBB+-rated company D if it borrows at the prevailing market floating-rates, however, it is able to save 100 bp (7% - 6%) over BBB+-rated companies should it borrows at the fixed-rate. Therefore Company C has a competitive advantage on the fixed-rate side of the market. Likewise, for BBB+-rated company, it will have to pay a premium of 100 bp relative to AA-rated companies at fixed-rate. However, it only has to pay a premium of 50 bp relative to AA-rated companies at floating-rate. Company D therefore has a competitive advantage on the floating-rate side of the market.

Say Company C wants to borrow £100,000,000 at floating rate for three years and Company D wants to borrow the same amount at fixed rate similarly for three years, i.e. both companies want to borrow at the weak sides of the market. Instead of doing so, they could borrow on what for them are the strong sides of the market and enter an interest rate swap convert their debts to the types they want. By doing so, the combined savings in interest expense can further reduced their borrowing costs. If they borrow at the weak side of the market, i.e. Company C at LIBOR + 10 and Company D at 7%, the combined interest would be LIBOR + 7.1% (assume interest calculations are the same). If instead they borrow at the strong sides of the market, the combined interest would be LIBOR + 6.6%, i.e. a combined savings of 50 bp.

Should they decided to benefit equally from this swap, then each party will benefit by 25 bp. Therefore Company C could lock in a cost of LIBOR + 10, with a benefit of 25 bp, the total all-in cost will be just LIBOR - 15. Likewise, Company D will have an all-in cost of 6.75%.

Valuing Swaps

There are several steps to value swaps:
1. Identify the cash flow.
2. Construct the swap curve, obtained from the government yield curve and the swap spread curve.
3. Construct a zero-coupon curve from the swap curve.
4. Present value the cash flows using the zero-coupon rates.

The swap spread is usually obtained from market makers (e.g. traders at financial institutions), the market-determined additional yield that compensates counterparties who receive fixed payments in a swap for the credit risk involved in the swap. Most swaps are priced to be at-the-money at inception, i.e. value of floating-rate cashflows is identical to the value of fixed-rate cashflows.

Written by Henry Tang.

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