The derivatives market is vast, and it witnesses multiple participants in the form of institutional investors, insurance companies, hedge funds, as well as retail investors. Derivative contracts obtain their value from underlying assets; the underlying asset in question could be stocks, government securities, currencies, interest rates, etc. That said, there are mainly four types of derivatives contracts: futures, options, forwards, and swaps. In this article, we will cover swaps where the underlying asset is interest rates.
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Understanding Interest Rate Swaps
In a swap contract, two parties exchange liabilities or cash flows from two different instruments. An interest rate swap is a derivative contract in which two parties agree to exchange a stream of future interest payments for another. Since interest payments are based on the principal amount, generally, interest swaps involve the exchange of a fixed interest rate for a floating interest rate. Swaps, unlike exchange-traded derivative contracts like futures and options, are not standardised and are traded over-the-counter.
Working of an Interest Rate Swap
To understand how interest rate swaps work, let’s look at the most commonly traded interest rate swap—the fixed-to-floating interest swaps. For that, however, you must be familiar with the terms fixed rate interest and floating interest rates.
In the former, the interest rate levied on the debt or other security remains constant throughout the tenure or until the maturity of the security. In contrast, in the case of floating interest rates, the interest rates may fluctuate over time. This fluctuation depends on the underlying benchmark tied to interest rates. The underlying benchmark could be the LIBOR (London Interbank Offered Rate), FFR (Federal Funds Rate), MIBOR (Mumbai Interbank Outright Rate), CPI (Consumer Price Index), etc.
Thus, in the case of fixed-to-floating rate swaps, when the parties transact such swaps, they are essentially exchanging their loan arrangements, as they find the other party’s arrangement more lucrative. So, the party being paid fixed-interest exchanges that for variable interest. On the other hand, the risk-averse party receiving floating interest payments prefers the guaranteed fixed interest payment. The risk-averse party would prefer a fixed interest payment, as that protects them from rate changes and reduces debts. In contrast, a party with a higher risk tolerance would probably prefer floating interest payments if they speculated on an increase in interest rates.
However, it’s worth noting that only the interest payments are swapped. By no means are the parties taking ownership of the other party’s debt. There is no exchange of debt assets, and neither do the parties pay the full interest amount on each interest payment date. The swap contracts only require the parties to pay each other the difference in loan payments. The interest contracts are flexible, but a good one states the terms of the agreement clearly.
Examples of Interest Rates Swaps
Let’s look at an interest rate swap example to develop a crystal clear understanding of how an interest rate swap works.
- Assume there are two companies, P and Q, and they get into a contractual interest rate swap agreement. The nominal value of this contrast is ₹10,00,000, and the tenure of the contract is one year.
- Company P is a risk-averse company, so the company prefers securing a fixed interest payment. Conversely, Company Q is speculating on an increase in interest rates and is more comfortable with taking on some risk.
- Company Q agrees to offer Company P a fixed rate of 7% in exchange for a floating interest rate of the prevailing interest rate plus 2%. Let us assume the prevailing interest rate is 4%. At the same, further assume that the interest payments are made annually, and the floating interest is calculated based on the prevailing interest rate at the end of the tenure. Rates were raised twice during the tenure, each time by 1%. Before the interest payment dates, the prevailing interest rate stands at 6%.
- Thus, in this case, Company Q owes Company P the fixed interest return of ₹60,000 (7% of ₹10,00,000). On the other hand, due to a spike in the interest rates, P owes Q ₹80,000 (6% + 2% of ₹10,00,000).
- Here, Company Q’s willingness to take on extra risk by accepting the floating interest rate benefits it. However, in the absence of an interest rate hike, or, worse, in the event of a decline, Company Q would be negatively impacted by floating interest rates.
Types of Interest Rate Swaps
There exists other types of interest rate swaps besides the fixed-to-floating interest rate swaps. Let us look at three main types of interest rate swaps.
- Fixed-to-Floating: Here, a company that does not have access to a floating interest rate may swap its fixed interest rate with a counterparty offering a floating rate. So, in the above-discussed example, Company Q swaps its fixed interest for Company P’s floating interest.
- Floating-to-Fixed: The converse of the above-mentioned interest rate swap is also true. Risk-averse companies may look forward to exchanging their floating interest rate with counterparties offering a fixed rate. If you assess the above example from P’s perspective, they are getting into a floating-to-fixed interest rate swap agreement with Q.
- Float-to-Float: In the last type of interest rate swap, the parties involved may swap the type or tenor of the floating rate index that influences the interest rates. For example, a party may wish to swap their floating interest rate based on the MIBOR to a floating interest rate based on the FFR.
Advantages and Disadvantages of Interest Rate Swaps
Advantages
- An interest rate swap is used to manage risk, as it allows a party to change its exposure to interest rate movements.
- Interest rate swaps are customisable contracts, so parties can customise the contract to meet their specific requirements.
- These contracts can help the trader take advantage of the differences in interest rates between markets.
Disadvantages
- The counterparty risk is the most serious. In simple terms, the other party is defaulting and unable to meet the contract’s obligations. However, due to strong balance sheets, this risk is mitigated if both parties are large institutions.
- The unpredictable nature of the floating interest rates.
Conclusion
To sum it up, interest rates are flexible derivative contracts that can help the trader/institution manage risk. By trading interest rate swaps, the trader/institution can either take advantage of fluctuating interest rates or protect themselves from the fluctuation. They help the company meet its cash flow requirements.
