What are Interest Rate Swaps?

In recent years, interest rate swaps have become an important component of the fixed-income market. With an interest rate swap, investors will typically exchange or swap a fixed-interest payment for a floating-rate interest payment. Investors use these contracts to hedge or to manage their risk exposure.

A financial advisor can help you understand how interest rate swaps or other derivatives play a role in your portfolio.

Interest Rate Swaps Explained

An interest rate swap exchanges of interest rates between two parties. It swaps one stream of future interest payments for another. Interest rate swaps are derivatives and will trade over the counter. The most common interest rate swaps are known as vanilla swaps. A vanilla swap is an exchange of fixed-rate payments for a floating rate payment. This exchange rate is based on the London Inter-Bank Offered Rate (LIBOR), which is the interest some banks charge each other for short-term financing. LIBOR is set daily and is the benchmark for short-term interest rates. While there are other types of interest rate swaps, vanilla swaps tend to make up most of the market.

Financial institutions such as investment and commercial banks are swap known as market makers. These banks tend to have strong credit ratings and can offer fixed and floating rates to their clients. Typically, on one side of the swap, you will find the receiver or seller. They can be a corporation, bank or investor. On the other side of the transaction, you’ll find the payer. They may be investment or commercial bank.

The Broker’s Role

Once the bank decides to move forward with a swap, they will go through an inter-dealer broker. This inter-dealer broker will receive a fee for managing and setting up the original swap. Depending on the size of the swap, the broker may sell it to several receivers. This helps minimize the risk involved in the transaction.

By allowing corporations to pay fixed interest rates, the rate swaps can help them manage their floating debt liabilities. The corporations can then lock in a new rate and receive payments that may coincide with their floating rate debt. Because these swaps may reflect the interest rate forecasts, swaps can be an attractive tool for many other market participants.

Advantages

Since the adjustable-rate payment ties to LIBOR, the receiver’s bond may feature lower interest rates slightly above LIBOR. But they may prefer the predictable nature of fixed payments even though they have a slightly higher rate. By having fixed rates, the receiver can then predict more accurate earnings. Stock prices may raise when they eliminate this risk. Because the company may have a stable cash flow, it may not need a large emergency fund with cash reserves.

Because banks need a reliable stream of income to afford their liabilities, banks often take out short-term loans that tend to have floating rates to pay their daily expenses. Therefore, banks may swap their fixed-rate payments for a company’s floating rate. Since banks receive the best interest rates, they may even receive higher payments from the company they swapped with, which is beneficial to the bank.

Another advantage is that if the payer has a bond with higher interest payments, they may want a lower payment that’s close to LIBOR. If the payer thinks rates are going to stay low, they might be willing to take on the extra risk of a floating rate. That said, the payer may have to pay more if they decided to take out a fixed-rate loan. Essentially, the floating-rate loan’s interest rate including the fee for the interest rate swap might be less expensive than a fixed-interest loan.

Disadvantages

Because investors and hedge funds may use interest rate swaps to speculate, which may increase market risk. This is because they use leverage accounts which may only require a small down payment. They then offset the risk by using another derivative. If the markets turn against them then they won’t have to worry about coming up with payments.

However, if they win, they will be able to cash in. Conversely, if they lose, they may cause extreme market volatility since they must make a lot of trades at once.

Bottom Line

Interest rate swaps help companies manage their debt more effectively. The value of an interest rate swap is that a company bases their debt around fixed-rates or floating rates. When the company is receiving payments in either form but would prefer the latter, they can engage in a swap with another organization that has the opposite goal. That said, interest rate swaps can be advantageous to all parties involved.

However, like any other financial decision, there are risks. So before a company or investor signs the agreement, they must weigh out the pros and cons.

Investment Tips

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