The interest rate swap is a very efficient instrument. It can be constructed at extremely low cost and is probably less expensive than taking out a new fixed rate loan and using the proceeds to buy an offsetting floating rate security paying LIBOR.
Technically this would accomplish the same thing but it would surely be much more costly and time consuming to set up.
What is an Interest Rate Swap?
An Interest Rate Swap is an agreement between two parties who exchange interest payments, based on a notional principal amount, over an agreed period of time. Swaps are used to assist in the management of interest rates and cash flows.
Who would use a Swap?
A Swap can be used by borrowers who have a desire to alter their interest rate or cash flow profile to suit their particular needs.
Variable interest rate borrowers would use Swaps to hedge their interest costs in a market where variable interest rates are expected to rise while fixed rate borrowers would use a Swap to take advantage of lower interest rates in a market where variable interest rates are expected to fall.
Further, borrowers may use Swaps to alter the frequency of their cash flows. For example, annual interest payments can be converted into quarterly payments or quarterly payments into semi annual cash flows. This could be beneficial when your underlying cash flows have varied.
How does a Swap work?
An Interest Rate Swap means that you and the Bank have agreed to exchange the net difference between two different interest rates (commonly fixed versus floating). This exchange is based upon the amount you require at the frequency you require to match your needs; for example, quarterly interest.
The net difference between the two interest rates offsets the cash flows on the underlying borrowing. There is no exchange of principal.
For example, XYZ Corporation, who has borrowed on a variable interest rate basis, has formed the view that interest rates are likely to rise. They elect to pay fixed for the remaining term of the borrowing using an Interest Rate Swap, while their underlying borrowing remains variable, but hedged.
In this case, the two variable cash flows offset each other, thereby achieving a fixed rate for the borrower.
How much does a Swap cost?
There are no fees or other direct costs associated with Interest Rate Swaps. The price of an Interest Rate Swap is simply the fixed rate of interest at which the Swap is agreed between the Bank and yourself. The fixed rate will depend on the term of the Swap, the interest frequency and current market interest rates.
Can a Swap be used for future borrowings?
Yes. A Swap can be arranged to meet the interest rate and cash flow requirements of future borrowings.
For example our borrower, XYZ Corporation, has a fixed rate facility, which is due to rollover in six months time. Concerned that interest rates are rising, they want to secure fixed rate funding today for a further three years commencing on expiry of the current facility. XYZ enters into a three year Swap today, commencing in six months as the payer of the fixed interest rate. This Swap hedges the interest rate on the borrowing facility today giving comfort against future interest rate rises.
Are there any risks associated with an Interest Rate Swap?
Yes. By entering into an Interest Rate Swap you have expressed your view on interest rates and how they impact your borrowings. Should interest rate movements be different to your expectations, the Swap may have the opposite effect to what you were trying to achieve with the transaction. You can however, reverse or terminate the Swap should this start to happen (remembering you may be required to pay the Bank the difference or the Bank will pay you the difference between market interest rates and the Swap rate for the remaining term of the Swap).
The above information is not a recommendation or investment advise and appears for information purposes only. While information given believed to be reliable, ARAB BANK guarantee its accuracy or completeness, and accept no responsibility whatsoever (including any loss suffered by any company or individuals) resulting from trading on its basis. No rights can be gained from this publication. There are risk involved in this product.