Interest Rate Swap: Meaning, Types, Example, Advantages and Risks

What is an interest rate swap?

An interest rate swap (IRS) is a contractual arrangement between two parties who agree to exchange interest payments for a predefined amount of money (principal) and time. These contracts are a type of derivative contracts that trade over the counter (OTC) and can be customized as per the parties’ requirements.

Also known as plain vanilla swaps, they usually involve an exchange of a fixed interest rate contract for a floating interest rate contract and vice versa. This will help the parties reduce or increase their exposure to interest rate fluctuations and obtain a lower interest rate.

Interest rate swaps are usually used by companies when they prefer one type of interest rate over the other. In other words, if a company can obtain a fixed interest rate contract but prefers a floating interest rate contract, then it can use an interest rate swap.

The major players in interest rate swaps are banks and large and small corporations. In India, the Overnight Index Swap (OIS) is the most popular benchmark swap, and the Mumbai Interbank Offered Rate (MIBOR) is the floating benchmark against which companies settle swaps.

How does an interest rate swap work?

An interest rate swap is nothing but a simple contract where two parties exchange each other’s loan arrangement. So, if one party is paying a fixed interest rate to the bank and the other is paying a floating interest rate, but each party prefers the other’s loan arrangement over their own. Then, they will enter into a mutual agreement to exchange the loan terms.

When they enter into an agreement, only the interest payments are swapped. The loan amount, tenor and other payment terms remain the same. Since the interest rate swap is a derivative contract, both parties will pay each other the difference in the loan payments. They do not pay each other’s debt, nor do they pay the full interest of the other party.

A good swap contract clearly states the terms of the agreement, the payment each party has to make to the other party, the payment schedule, the start date, and the maturity date. Both parties will be bound to this interest rate swap contract until the maturity date.

The primary reason why a company enters into a swap contract is to take advantage of the change in interest rates. So, the party exchanging fixed interest rates for floating believes that the interest rates can rise in the future and wants to take advantage of it and earn high-interest rates. Whereas the party earning in floating exchange rate believes that it wants to be paid at a fixed rate as it guarantees an interest payment even if interest rates fall.

In a swap contract, both the parties get what they want. The company switching from fixed to floating will get exposure to earn a higher potential profit, whereas the company switching from floating to fixed wants to hedge the risk of a fall in interest rates. However, only one party will benefit from the contract. If the interest rates rise, the company receiving a floating rate will benefit from higher interest income, and the company receiving a fixed interest rate will be at a loss. Conversely, if the interest rates fall, the company receiving a floating interest rate will earn less, whereas the company with fixed interest payments will continue to receive the same interest payment.

Example of an interest rate swap

There are two companies, namely, ABC and DEF. Company AMC is currently paying a fixed interest to a bank for a loan (Rs 10 lakhs) it took. However, it believes that the interest rates could fall in the future and wants to benefit from the floating interest rate regime. Company DEF, on the other hand, is currently paying a floating interest rate on its bank loan (Rs 10 lakhs) but believes the interest rates could go up in the next few years, increasing its interest payments.

Company ABC and DEF enter into a swap contract to swap their interest rate terms. So, Company ABC will now pay a floating interest rate, and Company DEF will pay a fixed interest rate. Let’s say the fixed interest is 5%, and the floating interest rate is MIBOR plus 1%, with MIBOR being 4% currently.

To start off, both companies have the same interest payments on their loan of Rs 10 lakhs, which is Rs 50,000. After a year, if the MIBOR rate rises to 5%, then Company ABC will have to pay Company DEF the difference of 1%, which is Rs 10,000. However, if the MIBOR falls to 3%, then Company DEF will have to pay the difference of 2%, which is Rs 20,000 to Company ABC.

In the first scenario, Company ABC is at a loss as the interest rates have gone up, and in the second scenario, Company DEF is at a loss as the interest rates have gone down. Therefore, ultimately, only one party is benefitting from the interest rate swap contract.

Types of interest rate swap

There are three different types of interest rate swaps, namely fixed to floating, floating to fixed, and float to float.

Fixed to floating interest rate swap

In this type of swap, a company exchanges its fixed interest rate contract with a floating exchange contract. The party initially pays out a fixed interest rate but swaps it with a floating interest rate. So, after the swap, the party pays a floating interest rate and receives a cash flow of fixed interest rate. The interest is calculated on the notional principal amount, and the contract specifications, such as the tenor and interest payment frequency, are mirrored in the new contract as well. This type of contract is used when a company pays out a fixed interest rate to its bondholders but wants to swap it for a floating interest rate and receive the attractive interest rate instead.

Floating to fixed interest rate swap

Under this type of interest rate swap, the company swaps a floating interest rate to a fixed interest rate. Initially, the company is paying a floating interest rate but swaps it for a low fixed interest rate. Therefore, after the swap, the company will pay a fixed interest rate and receive a floating interest rate. All the contract specifications are mirrored in the swap contract, and the interest is calculated on the notional principal amount. This type of opt contract is used when a company wants to borrow money at a fixed interest rate but gets a floating interest rate instead. So, after the swap, the company will be borrowing at a fixed interest rate.  

Float to a float interest rate swap

This type of interest rate swap is known as a basis swap, as two companies enter into a swap contract to change the type of tenor of the floating rate index. They can also enter into this type of swap contract to change the benchmark index from MIBOR to government bonds or treasury bills. Companies use this type of contract to avail attractive interest rates or match the other payment flows. For example, a company which uses a three-month MIBOR might want to switch to a six-month MIBOR to ensure all its payment flows are of the same tenor. Alternatively, it might want to switch from MIBOR to other benchmark indexes such as the government bond.

Advantages of interest rate swaps

Access to financing: A company that has access to one type of financing can use interest rate swaps to get the type of financing it desires. For example, it can switch from fixed to floating or floating to fixed interest based on its requirements.

Risk management: Interest rate swaps also come in handy when a company wants to hedge its cashflows. If it is receiving a floating interest payment but wants to fix its cashflows, it can switch to another company that wants to benefit from fluctuations in the interest rate. This way, the company is fixing its cashflows to a certain amount.

Flexible: These contracts are flexible instruments that can be customised to each individual party’s needs. The contracts can be structured for hedging or speculation as per the party’s needs.

Risks of interest rate swaps

Interest rate risk: One of the biggest risks of interest rate swaps is the fluctuations in the interest rates. Interest rates are unpredictable and can increase the risk for both parties. If interest rates fall, the party with a fixed interest rate will stand to lose. In contrast, if interest rates rise, the party with a floating interest rate will have to shell out more money.

Credit risk: Interest rate swaps are subject to counterparty risks. There is a chance that the other party can default on its responsibility or payment obligations. However, this risk can be managed by using collateral or credit limits.

Basis risk: If both parties use different benchmarks, the relationship between different interest rates will change over time. This might cause the cashflows to be misaligned with the underlying debt. However, it can be mitigated by using float-to-float swaps with similar benchmarks or adjusting the terms of the swap.

Frequently Asked Questions

Who can enter into an interest rate swap?

Interest rate swaps are for governments, corporations, institutional investors, hedge funds, and other financial entities. Retail investors cannot enter into an interest rate swap.

What is the difference between interest rate and swap rate?

The swap rate is a special interest rate used for calculating fixed payments in the interest rate swap contract. It remains constant throughout the duration of the swap contract and is usually the fixed interest rate of the contract. Interest rate, on the other hand, is the fixed or floating interest rate that the party owes to their lender, usually the bank.

What is the purpose of interest rate swap?

Interest rate swap is used to hedge the risk of interest rate changes. It is also used to speculate and earn profit from changing interest rates. The parties to the interest rate swap contract will have contrasting views about the interest rates and, hence, enter into a contract to either manage risk or make money.