Motivation for interest rate swaps

The circumstances that give rise to interest rate swaps (IRSs) usually involve interest rate risk or comparative advantage. The following main IRSs may be identified:

• Transforming a liability.

• Transforming an asset.

• Comparative advantage.

Coupon swap: transforming a liability

An example of an IRS that transforms a liability is shown in Figure 3.

interest rate swap: transforming a liability

Figure 3: interest rate swap: transforming a liability

In this example Company A has borrowed LCC100 million through the issuing of 91-day commercial paper (which is re-priced every 91 days at the then prevailing rate), while Company B has borrowed LCC100 million by the issuing of corporate bonds at a fixed rate of 12% pa for a 3-year period. These borrowing habitats could reflect the following:

• Company A believes interest rates are going to move down or sideways. It therefore does not want to "lock in" a rate for a long period, and wants to take advantage of rates declining if this does come about.

• Company B is of the view that rates are about to rise and wishes to lock in a rate now for the next three years.

Time passes and the two parties change their views. A sharp banker spots the changed views of the two companies and puts the following deals to them:

Company A

• Company A and the bank enter into an interest rate swap agreement.

• Company A agrees to pay to the bank a fixed rate of 12.1% for the next three years, interest payable six-monthly.

• The bank agrees to pay Company A the floating commercial paper rate every 91-days.

• The notional amount of the swap is LCC100 million.

Company B

• Company B and the bank enter into an interest rate swap agreement.

• Company B agrees to pay to the bank the commercial paper floating rate every 91 days.

• The bank agrees to pay to Company B paying a fixed rate of 12.0%, interest payable six-monthly.

• The notional amount of the swap is LCC100 million.

Because of their changed views, the deals are accepted by both companies. Company A's obligation to pay the 91-day commercial paper rate to the holders (which may be different in each rollover period) is matched by the bank's payment of the 91-day commercial paper rate to it. It is then left only with the obligation to pay the fixed rate of 12.1% pa to the bank.

Conversely, Company B's obligation to pay the fixed 12% pa to the investors in its paper is matched by the bank's obligation to pay the fixed 12% pa rate to it. Company B is thus left with the obligation to pay the 91-day commercial paper rate to the bank.

The interest obligations of the bank match, with the exception that the bank earns 0.1% on the fixed interest leg of the transaction (LCC100 000 per annum excluding compounding and present value calculations).

The mathematics of this deal is straightforward, and simply amounts to interest payments (i.e. cash flows) over the three-year period. The cash flows are shown in Table 1.

Company B pays

Floating rate (% pa) assumed

Year 1

Day 0

-

-

-

Day 91 (91 days)

2 966 849.32

11.9

Day 182 (91 days)

6 050 000

2 991 780.82

12.0

Day 273 (91 days)

3 066 575.34

12.3

Day 365 (92 days)

6 050 000

3 166 301.37

12.7

Year 2

Day 91 (91 days)

3 241 095.89

13.0

Day 182 (91 days)

6 050 000

3 365 753.43

13.5

Day 273 (91 days)

3 490 410.96

14.0

Day 365 (92 days)

6 050 000

3 427 945.21

13.6

Year 3

Day 91 (91 days)

3 340 821.92

13.4

Day 182 (91 days)

6 050 000

3 116 438.36

12.5

Day 273 (91 days)

2 991 780.82

12.0

Day 365 (92 days)

6 050 000

2 867 123.29

11.5

Total

36 300 000

38 032 876.73

Table 1: Fixed for floating interest rate swap (fixed rate = 12% pa) (LCC)

Company A's floating rate obligation is cancelled out by the matching payments from the bank, and Company B's fixed rate obligation is cancelled out by the payments from the bank. Company A thus over the period of 3 years paid out a total of LCC36.3 million in interest, compared with Company B's LCC38 032 876.73. Thus, Company As amended interest rate view was correct, and it saved LCC1.7 million. Company B's treasurer should have stuck to his original view.

Counterparty risk

It is rare that counterparties in swap deals are able to find one another and do a deal to their mutual satisfaction. If they do, the deal rests on the integrity of the two parties, i.e. they are each exposed to counterparty risk. More generally, it is bankers that seek out these transactions.

The banks then interpose themselves between the clients (principals), and undertake to receive and pay the relevant interest amounts. Clearly, it is only the large banks that are able to do these deals, because the counterparty of each principal is the intermediary bank (sometimes called the swap agent).

Fixed rates and floating rates

The above was an example of a plain vanilla swap. The floating rate used was the 91-day commercial paper rate. Most swaps in reality involve other well-known benchmark rates, such as the LIBOR in the UK, the Fed funds rate in the US, the ROD or JIBAR rates in South Africa, and so on. The fixed leg is not benchmarked because it is an agreed number.

 
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