Interest rate swaps (IRS)

An interest rate swap (IRS) is an derivative agreement between two counterparties to exchange streams of cash flows based on interest rates to each other on defined dates. They are specific to each clients circumstance and needs and therefore are Over-the-counter (OTC) agreements negotiated individually instead of standardised on an exchange.

The most commonly traded IRS is the plain ‘vanilla’ IRS which exchanges a fixed interest rate payment from one party for a floating LIBOR rate, the “London Interbank Offering rate” of high quality banks towards one another each day, of another.

Typical counterpart participants in a ‘vanilla’ IRS are corporations, investors and commercial or investment banks. The IRS derivative contract allow a fixed rate to those parties with floating rates who wish to be otherwise or vice versa.

The market is exceptionally important to the fixed income market and has grown to contract interest swaps on $230Tn of loans.

Risks associated with IRS derivatives
Interest swaps involve two associated risks: interest risk and counterparty risk.

Actual interest rates in the future might not match the expectations of the participants in the swap. If Counterparty A wishes to pay fixed instead of floating because they believe that interest rates will rise and wish to lock in a cheaper payment, but interest rates actually fall. The party will be left paying a higher interest than if they had stayed on floating decreasing their payment with LIBOR.

Conversely if Counterparty B wants floating due to their expectation of falling rates, allowing them a cheaper payment, but rates rise they are also liable for higher payments than their expectation allowed them.

Let’s explain the IRS derivative contract using an example:
Both parties wish to take out a loan of $10m for 5 years at the lowest possible rates, this will be the basis of their swap referred to as the notional amount.

Counterparty A (LogicTank) has access to funds at either 9.00% fixed rate or +1.50% LIBOR
Counterparty B (Artitectuur) has access to fund at either 7.3% fixed rate or +0.50% LIBOR

The fixed rate once agreed will never change, it contractually stays the agreed amount. LIBOR + on the other hand floats with the change in interbank lending which is announced everyday at 11:00 Greenwich mean time. So that if LIBOR is at 5% then Counterparty A pays 5% + 1.5% = 6.5% or if LIBOR changes to 4.3% it will pay 4.3% + 1.5% = 5.8%.

They can both transact in their preferred markets or they can enter into an agreement with each other to exchange cash flows and mutually benefit.

Both wish to reduce the risk exposure to interest rates on their desired loans of $10m each, but have different opinions on how they will move. Counterparty A wants a fixed rate believing that interest rates will rise and this will reduce their exposure to this movement making it easier to plan for future operations. Counterparty B wants a floating rate believing that rates will fall and they can generate lower payment costs.

In this situation both parties can swap their rates towards each other to receive their desired outcome.

IRS

Clearly the table shows that Counterparty B has a comparative advantage in the floating market (1%) than the fixed (1.7%). Meaning than in borrowing investors want a risk premium from Counterparty A of 1.7% fixed and 1% floating reflecting its overall credit rating.

Where a comparative advantage exists both parties can mutually benefit by borrowing at their comparative advantage, instead of their desired advantage, and sharing the savings they both make. The absolute advantage is the difference between the two comparative values: 1.7% – 1% = 0.7% or 70 basis points, this is the rate difference for sharing between the two parties.

Counterparty Fixed Rate Floating Rate
Counterparty A 9.00% 1.50%
Counterparty B 7.3% 0.50%
Comparative Advantage 1.70% 1.00%

Even though company B requires LIBOR it will loan on a fixed rate of 7.3% and Counterparty A which will borrow at LIBOR 1.50% in the floating rate market taking their relative comparative advantage.

Then both parties can split the absolute advantage by negotiating and exchanging their own interest rates based on the same notional amounts. Counterparty A will go short and will pay Counterparty B the fixed rate of 7.5%, instead of 9%, and Counterparty B will go long and will pay Counterparty A the floating rate of LIBOR + 0.50%, instead of LIBOR + 1.50%.

Therefore Counterparty A will have a fixed net payment of 8.50% instead of LIBOR + 1.50% because now they will pay the original floating payments and receive a floating payment netting the difference and paying Counterparty B a fixed rate instead.

Counterparty B will have a floating net payment of LIBOR + 0.30% instead of a fixed payment of 7.3% because they can now net their received fixed payment off Counterparty A and pay LIBOR + instead.

Therefore when payment is due on the loan what happens assuming LIBOR is at 4% in period 1 and 5.3% in period 2.

Period 1

  • Counterparty A would pay the original loans interest of LIBOR (4%) + 1.50% = 5.5% of $10m which is $550,000

    But now it also pays a fixed rate to Counterparty B of 7.5% of $10m which is $750,000

    Total payment of $1,300,000

  • Counterparty B pays the original loans interest of 7.3% of $10m which is $730,000

    But now it also pays Counterparty A the floating rate of LIBOR (4%)+ 0.5% = 4.5% of $10m which is $450,000

    Total payment of $1,180,000

But then both parties pay each other their comparative amounts through the IRS and net the difference so that:

Counterparty A pays $1,300,000 – $450,000 = $850,000
Counterparty B pays $1,180,000 – $750,000 = $430,000

Period 2

  • Counterparty A would pay the original loans interest of LIBOR (5.3%) + 1.50% = 6.8% of $10m which is $680,000

    But now it also pays a fixed rate to Counterparty B of 7.5% of $10m which is $750,000

    Total payment of $1,430,000

  • Counterparty B pays the original loans interest of 7.3% of $10m which is $730,000

    But now it also pays Counterparty A the floating rate of LIBOR (5.3%)+ 0.5% = 5.8% of $10m which is $580,000

    Total payment of $1,310,000

But then both parties pay each other their comparative amounts through the IRS and net the difference so that:

Counterparty A pays $1,430,000 – $580,000 = $850,000
Counterparty B pays $1,310,000 – $750,000 = $560,000

This goes for all periods – where Counterparty A started with a floating rate it now has a fixed rate:

Counterparty A Period LIBOR Outwards Floating cash flow (LIBOR + 1.50%) Outwards Fixed cash flow (7.5% IRS) Received Floating cash flow (LIBOR + 0.50%) Net cash flow
1 4.00% -$550,000 -$750,000 $450,000 $850,000
2 5.30% -$630,000 -$750,000 $580,000 $850,000
3 6.53% -$800,300 -$750,000 $700,300 $850,000
4 7.42% -$892,000 -$750,000 $792,000 $850,000
5 8.98% -$1,048,000 -$750,000 $948,000 $850,000

Counterparty A which took out LIBOR + 1.50% now essentially pays a fixed rate of 8.50%, instead of 9% due to the netting effect of IRS payments to each party. This is due to the definite payment of LIBOR + 1.50% + 7.50% IRS = LIBOR + 9.00% – 0.50% IRS.

Total 8.50% of $10,000,000 = $850,000 Fixed rate.

While Counterparty B which took out a fixed rate of 7.3% now essentially pays a floating rate of LIBOR + 0.30, instead of LIBOR + 0.50% through netting the IRS payments. This is due to the definite payment of the fixed rate of 7.3% + LIBOR + 0.5% IRS = LIBOR + 7.80% – 7.50% IRS.

Total LIBOR + 0.03% of $10,000,000 = LIBOR + $300,000 Floating rate.

The absolute advantage of 0.70% or 70 basis points has been shared:

Instead of 9% Counterparty A now pays 8.5% a difference of 0.5% and Counterparty B instead of paying LIBOR + 0.50% now pays LIBOR + 0.3% a difference of 0.2% – a total saving of 0.70% (0.5% + 0.2%). Lowering the cost of borrowing for both parties.

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