CFM13320 - Understanding corporate finance: derivative contracts: interest rate swaps

Using an interest rate swap

Futures and forward rate agreements are used to hedge short-term interest rate exposures. Interest rate swaps can be used to hedge much longer term exposures, or to obtain lower cost funding. The most straightforward type of interest rate swap involves swapping a fixed rate of interest for a floating rate of interest.

Example

Rhulipp plc is the parent company of a UK manufacturing group, which needs to borrow £50 million over 7 years. Ideally, it would like to raise the funds by issuing fixed rate bonds with a 7-year maturity. However, its credit rating is no better than BBB, so it would have to issue bonds with a significantly higher interest coupon than risk-free investments such as gilts, in order to compensate investors for the greater risk. It calculates the required interest coupon to be 6.6%.

Instead of issuing fixed rate bonds, the company issues 6-month commercial paper, rolling over this short-term borrowing every 6 months. It pays interest of 6- month LIBOR plus 0.3% on this borrowing. At the same time, it enters into a 7-year interest rate swap with a bank, with payments being exchanged semi-annually. The swap is based on a notional principal amount of £50 million. The company receives floating rate interest at 6-month LIBOR, and pays fixed rate interest at 6.1%:

In effect, Rhulipp plc is paying a fixed rate of 6.4% for its funding: the 6.1% fixed rate payable under the swap agreement, plus a premium of 0.3% on its floating rate commitments, that is not being reimbursed by the bank. This gives the company the desired fixed rate funding, but at a lower cost than issuing bonds.

Floating to floating swaps

It is also possible to swap a floating rate of interest for a different floating rate: 3-month LIBOR for 6-month LIBOR, for example. This is called a basis swap. A company may enter into a swap of this sort to even out a mismatch between interest receipts coming in, and interest which it has to pay out.

An interest rate swap does not necessarily have to be in sterling. The notional principal amount might be denominated in, for example, euros, with one party paying a fixed rate of euro interest and the other a floating rate of euro interest. But if more than one currency is involved, it becomes a currency swap - see CFM13420.