Interest rate swap: meaning, benefits and types

Interest rate swaps help exchange fixed or floating interest rates to reduce or increase the exposure to interest rate fluctuations.
 

Companies need funds to expand and grow their business. They usually acquire money from banks, which charge interest at a rate that depends on many factors. It can increase as well as decrease, which isn't ideal for all companies. An interest rate swap helps companies customise their interest rate based on a specified principal amount.

It commonly involves an exchange between fixed to floating interest rates or vice versa and helps marginally reduce companies' borrowing costs. This article gives an insight into the interest rate swap, its benefits, and its types.

What is the meaning of an interest rate swap?
 

Interest rate swap helps institutions manage their risks due to fluctuation in the interest rates. It is a contract between stakeholders where interest payments are exchanged according to their needs.

It involves an exchange of a floating interest rate for a fixed rate or vice versa. Swaps help marginally lower the interest rates that need to be paid or reduce/increase the exposure to fluctuating interest rates. OIS (Overnight Index Swap) is amongst the most popular benchmark swaps due to its liquidity.

Understanding interest rate swap
 

Interest rate swaps are used to exchange cash flow to minimise losses due to fluctuating interest rates. Since most transactions are performed over the counter, an interest rate swap helps the involved parties customise their contracts as per the desired specification.

Types of interest rate swap
 

Here are three different types of interest rate swaps.

• Fixed-to-floating interest rates swap: In this type of interest rate swap, a customer enters the contract, receives cash flow through a fixed interest rate, and pays out at floating interest rates. The amount of interest is calculated on a predetermined principal amount. The floating interest rates are referenced through the MIBOR benchmark set daily.
• Floating-to-fixed interest rates swap: In this type of interest rate swap, a customer enters the contract, receives cash flow through floating interest rates, and pays out at fixed interest rates. Again, the interest is calculated on a specified principal amount.
• Float-to-float interest rate swap: In this kind of interest rate swap, the companies enter a contract and exchange receipts on a specified principal amount based on floating rates referenced at two separate benchmarks. The companies can also use float-to-float interest swap to change the tenure or type of floating-rate index to get attractive rates.

What is the swap rate?
 

The swap rate is the fixed interest rate demanded by the receiver against the uncertainties of paying short-term MIBOR floating rates. At the time of the swap agreement, the entire fixed rate flow remains equal to the forecasted floating-rate payment as depicted by the forward MIBOR curve. Swap rates are usually quoted in fixed-rate or swap spread. The swap spread is the difference between the swap rate and the government's bond yield during similar maturity. 

How does the swap contract work?
 

When the swap contract is established, the total amount of fixed interest rate is considered equal to the forecasted floating interest rate cash flow. However, the floating interest rates fluctuate and can eventually incur losses to the cash flow receiver. If the interest rate swap becomes unprofitable, the counterparty can exchange countervailing swaps for shedding the interest rate risk of the swap.

How to invest in an interest rate swap?
 

For investors and corporate treasurers, interest rate swaps are an essential financial tool. Following are the ways to invest in interest rate swaps.

• Portfolio management: Interest rate swaps help adjust the interest exposure and minimise the risks of interest rate volatility. Risk managers can reduce fluctuations and increase profits by changing the interest rate exposure per requirement. In addition, the interest rate swaps can also act as a less liquid fixed income investment tool.
• Corporate finance: Companies with MIBOR-linked loans or other floating rate liabilities can enter an interest rate swap and pay a fixed rate while receiving floating cash flow.
• Risk management: Financial institutions and banks process huge transactions in the form of loans, investments, and derivative contracts. The interest rate swap helps offset the fluctuating interest rate risk for such transactions.
  

Interest rate swap helps corporates and investors minimise interest rate risks. By swapping fixed and floating interest rates, risk managers can make profitable deals while maintaining optimal cash flow per the company's requirements. Interest rate swapping can also offer opportunities for low liquidity fixed-income investments.

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