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Interest Rate Swap

What is an Interest Rate Swap?

An Interest Rate Swap is a contractual agreement between two counterparties, the Borrower and the Bank, to exchange interest payments on a pre-agreed profile. The Borrower agrees to pay a pre-agreed fixed rate of interest in return for receiving a floating rate that matches the loan (i.e. three month LIBOR) from the Bank. In most cases, the Bank counterparty will also be the Lender.

Figure A:

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

Objectives

The purpose of the Swap is to fix the cost of finance for a Borrower who has floating rate borrowings, thus protecting them from changes in short-term interest rates.

How does it work?

The Borrower will have entered into a contract 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 rate and the floating rate, and if below, the Borrower will make a net payment to the Bank. The result is that the effective cost of funds will remain at the contracted fixed rate no matter where the floating rate fixes.

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

 

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