What does a swap in interest rates mean?

Any interest rate swap is a forward deal where one stream of future interest payments is traded for another based on a set amount. Interest rate swaps usually involve trading a set interest rate for a floating rate or vice versa. This can be done to lower or raise your exposure to changes in interest rates or to get a slightly lower interest rate than you could have gotten without the swap.

Trading one type of floating rate for another in a swap is possible. This is known as a base swap.

How Interest Rate Swaps Work: A Guide

Interest rate swaps are deals where one set of cash flows is traded for another. Because they are traded over the counter (OTC), the contracts are between two or more parties and can be changed in any way they want.

Swaps are often used when a business can quickly receive money at one interest rate but would rather have a different one.

Different Kinds of Rate Swaps

There are three kinds of interest rate swaps: float-to-float, fixed-to-float, and fixed-to-float.

From Fixed to Floating

Take TSI as an example of a company that can sell a bond with a set interest rate that investors will like. The people in charge of the business think a flexible rate will help it get more cash. Here, TSI can deal with another bank to swap, where the company pays a floating rate and gets a set rate.

The swap is set up to meet the fixed-rate bond’s maturity date and cash flow, and the two fixed-rate payment streams are added together. TSI and the bank pick the floating-rate tracker they like best for a one-, three-, or six-month maturity. This is usually the London Interbank Offered Rate (LIBOR). Then, TSI gets the LIBOR plus or minus, a range that shows its credit rating and the interest rates on the market.

After December 31, 2021, the Intercontinental Exchange, which is in charge of LIBOR, will no longer release one-week and two-month USD LIBOR. After June 30, 2023, there will be no more LIBOR.1

From Floating to Fixed

If a business can’t get a loan with a set rate, it can borrow money at a variable rate and then swap to get a fixed rate. On the loan, the reset, payment, and floating-rate tenor dates are all reflected on the swap and added together. The fixed-rate part of the swap becomes the rate at which the company borrows money.

Jump from Float to Float

They will sometimes do a swap to change the type or length of the fixed-rate index that a company pays. This is called a basis swap. A business can change its LIBOR rate from three months to six months if the six-month rate is better or fits with other payments. A business can switch to a different measure, like government funds, commercial paper, or Treasury bill rates.

An example of an interest rate swap in the real world

Suppose PepsiCo needs to get $75 million to buy a rival company. There is a chance that they could borrow the money with only a 3.2% interest rate outside of the U.S. If they did, it would cost them 3.5%. The catch is that they would have to print the bond in a currency other than their own, and the value of that currency could change depending on the interest rates in their home country.

For the bond’s life, PepsiCo could change interest rates. According to the deal, PepsiCo would pay the other party 3.2% interest on the bond for the life of it. The company will trade $75 million for the agreed-upon exchange rate when the bond matures. This way, the company would not be affected by changes in the exchange rate.

That sounds like a strange name for something.

When two people trade (i.e., swap) future interest payments based on a certain capital amount, this is called an interest rate swap. One of the main reasons banks use interest rate swaps is to protect themselves from losses and control credit risk or trade. Interest rate swaps are bought and sold on over-the-counter (OTC) markets. They are made to fit the needs of both parties. A vanilla swap, which trades a set exchange rate for a floating rate, is the most common type.

What does an interest rate change look like?

Let’s say that Company A put out $10 million in two-year bonds with an interest rate that changes monthly and equals the London Interbank Offered Rate (LIBOR) plus 1%. Let us say that LIBOR is 2%. The company fears that interest rates will go up, so it finds Company B that will pay Company A the LIBOR yearly rate plus 1% for two years on a $10 million loan. As payment, Company A gives Company B a set rate of 4% on a $10 million loan for two years. Company A will do well if interest rates go up a lot. Company B will gain if interest rates stay the same or go down.

Rate changes come in a few different forms.

There are three main types of interest rate swaps: fixed-to-floating, floating-to-fixed, and float-to-float. A fixed-to-floating swap is when one company gets a fixed rate and pays a floating rate because it thinks a floating rate will bring in more cash. A floating-to-fixed swap is used when a company wants to get a set rate to protect itself from changes in interest rates. Finally, a float-to-float swap, also called a basis swap, is when two parties agree to trade interest rates that change over time. For example, a LIBOR rate could be switched to a T-bill rate.

Conclusion

• Interest rate swaps are forward contracts that trade one stream of future interest payments for another based on a set amount of capital.
• Interest rate swaps let you trade set or floating rates to lower or raise your risk of losing money when interest rates change.
• Plain vanilla swaps are another name for interest rate swaps. This is because they were the first and often the most accessible type of swap instrument.