Interest Rate Swaps Explained for Dummies Example amp Definition
Interest Rate Swaps Explained for Dummies - Example & Definition Skip to content
You own shares of Apple, Amazon, Tesla. Why not Banksy or Andy Warhol? Their works’ value doesn’t rise and fall with the stock market. And they’re a lot cooler than Jeff Bezos.
Get Priority Access The theory is that one party gets to hedge the risk associated with their security offering a floating interest rate, while the other can take advantage of the potential reward while holding a more conservative asset. It’s a win-win situation, but it’s also a zero-sum game. The gain one party receives through the swap will be equal to the loss of the other party. While you’re neutralizing your risk, in a way, one of you is going to lose some money. Interest rate swaps are traded over the counter, and if your company decides to exchange interest rates, you and the other party will need to agree on two main issues: Length of the swap. Establish a start date and a maturity date for the swap, and know that both parties will be bound to all of the terms of the agreement until the contract expires.Terms of the swap. Be clear about the terms under which you’re exchanging interest rates. You’ll need to carefully weigh the required frequency of payments (annually, quarterly, or monthly). Also decide on the structure of the payments: whether you’ll use an amortizing plan, bullet structure, or zero-coupon method. To illustrate how a swap may work, let’s look further into an example. ABC Company and XYZ Company enter into one-year interest rate swap with a nominal value of $1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1%, since both parties believe that LIBOR will be roughly 4%. At the end of the year, ABC will pay XYZ $50,000 (5% of $1 million). If the LIBOR rate is trading at 4.75%, XYZ then will have to pay ABC Company $57,500 (5.75% of $1 million, because of the agreement to pay LIBOR plus 1%). Therefore, the value of the swap to ABC and XYZ is the difference between what they receive and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a gain of $7,500, while XYZ realizes a loss of $7,500. Generally, only the net payment will be made. When XYZ pays $7,500 to ABC, both companies avoid the cost and complexities of each company paying the full $50,000 and $57,500.
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By Kalen Smith Date September 14, 2021FEATURED PROMOTION
An interest rate swap is a financial derivative that companies use to exchange interest rate payments with each other. Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead. Each group has their own priorities and requirements, so these exchanges can work to the advantage of both parties.How Interest Rate Swaps Work
Generally, the two parties in an interest rate swap are trading a fixed-rate and variable-interest rate. For example, one company may have a bond that pays the London Interbank Offered Rate (LIBOR), while the other party holds a bond that provides a fixed payment of 5%. If the LIBOR is expected to stay around 3%, then the contract would likely explain that the party paying the varying interest rate will pay LIBOR plus 2%. That way both parties can expect to receive similar payments. The primary investment is never traded, but the parties will agree on a base value (perhaps $1 million) to use to calculate the cash flows that they’ll exchange.You own shares of Apple, Amazon, Tesla. Why not Banksy or Andy Warhol? Their works’ value doesn’t rise and fall with the stock market. And they’re a lot cooler than Jeff Bezos.
Get Priority Access The theory is that one party gets to hedge the risk associated with their security offering a floating interest rate, while the other can take advantage of the potential reward while holding a more conservative asset. It’s a win-win situation, but it’s also a zero-sum game. The gain one party receives through the swap will be equal to the loss of the other party. While you’re neutralizing your risk, in a way, one of you is going to lose some money. Interest rate swaps are traded over the counter, and if your company decides to exchange interest rates, you and the other party will need to agree on two main issues: Length of the swap. Establish a start date and a maturity date for the swap, and know that both parties will be bound to all of the terms of the agreement until the contract expires.Terms of the swap. Be clear about the terms under which you’re exchanging interest rates. You’ll need to carefully weigh the required frequency of payments (annually, quarterly, or monthly). Also decide on the structure of the payments: whether you’ll use an amortizing plan, bullet structure, or zero-coupon method. To illustrate how a swap may work, let’s look further into an example. ABC Company and XYZ Company enter into one-year interest rate swap with a nominal value of $1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1%, since both parties believe that LIBOR will be roughly 4%. At the end of the year, ABC will pay XYZ $50,000 (5% of $1 million). If the LIBOR rate is trading at 4.75%, XYZ then will have to pay ABC Company $57,500 (5.75% of $1 million, because of the agreement to pay LIBOR plus 1%). Therefore, the value of the swap to ABC and XYZ is the difference between what they receive and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a gain of $7,500, while XYZ realizes a loss of $7,500. Generally, only the net payment will be made. When XYZ pays $7,500 to ABC, both companies avoid the cost and complexities of each company paying the full $50,000 and $57,500.