Hello all, I need some help from forum members. I read about the basic interest rate swaps, and how if one has taken a fixed rate loan and the other has a variable interest loan, they can swap on notional amount and pay the netted amount to each other. How does this relate to real business scenario, can anyone please explain or give a real example how this is used in real businesses. Thanks a lot in advance.
One way of looking at an interest rate swap is the fixed payer is betting the interest rates will rise, and the variable payer betting they will fall. Its best if you look on page 380 Volume 5 as that is where a swap is initially explained. Basically without a swap, a company paying a floating rate loan on an asset is exposed to interest rate risk which could result in a negative income spread (return on asset - funding cost) with an interest rate swap a company can lock in a guaranteed spread on the asset and funding cost regardless of the variable rate it pays. the example shows a company that pays the floating rate thinks the interest rates will fall (it pays a smaller amount of interest than it receives = gain). swaps can be very beneficial to both companies. for example currency swaps are used to reduce expense volatility for companies conducting business in other countries because the exchange rate wont cause large or small expenses from period to period.
You want to buy a new office building. 20 year mortgage, really ridiculous rent. And you have to decide 1) Rates are so low right now, I should get my self a floating rate loan and pay almost nil 2) But they can go higher and I can lock in a fix rate mortgage for an affordable rate Your CFO says “man, Obama-economics sucks monkey balls, rates are gonna be low for decades”. You decide to take the loan at the current almost-0% rate with UBS. But alas, rates go up, and up, and up. And they are at 4% a couple of years later and only seem to go higher; it’s starting to really hurt your budget. You want to refinance the loan but UBS says: “screw you mo-fo, rates are gonna go up, all I want is my doe every month” So you go to DB which are really cool about it and let you do a PAYER SWAP. With it, you agree to PAY FIX RATE (4% at the time) during the duration of your loan and RECEIVE FLOATING (your first rate at point 1) With that floating payment DB gives you, you payback your loan to UBS, so from that point onward you now have a fix-rate mortgage with DB. Wanna continue the story and say what happens when we enter a double-dip recession and rates go further down? What would you like to do then?
> One way of looking at an interest rate swap is the fixed payer is betting the interest rates will rise, and the variable payer betting they will fall. Not really. The market pays you to take on risk, so if you pay floating rate, your expected cost is lower than if you pay fixed rate. (compare historical average of 3m LIBOR vs 10y rate) Depending on individual risk-reward tradeoffs, you may be more or less comfortable taking on this risk for the market-prevailing price. If you’re highly levered, facing large interest expenses, the increased risk may threaten your compliance with lender covenants or rating agencies.
Most high end corporate lending is done on a variable rate basis, tied to Libor. So if a company borrows $100 million for 5 years from a bank they will pay a variable interest rate that is very low in the current market, but has the potential to rise during the 5 year life of the loan. To lock in the low rate the company will do an interest rate swap to fixed, which might mean that their locked in rate is a bit above what the current varibale rate is, but it protects the company in case rates increase steeply.
Thank you so much guys, all these answers make a lot of sense now about interest rates swaps. Baystreet - pg 380-381 example is really good and simple. AntonioY - Great explaining…in a way the way you explain is so true right now every lending of money if you can get it is so cheap so the banks are going to make good money sooner or later on these instruments because the rates will surely go up one day. Thank you all again.