Interest Rate Swap (IRS)

What is an Interest Rate Swap?

An interest rate swap is an agreement between two counterparties to exchange two cash flow streams, known as swap legs. These swaps typically involve exchanging a fixed interest rate for a floating interest rate over a fixed period of time.

Investment banks and finance boutiques are usually the market makers for the swaps market and assist their clients with such borrowing requirements. Clients are typically corporations, other banks and individual investors who are looking to de-risk any movements in interest rates. IRS are usually customized to the specific requirements of the clients and thus trade over-the-counter, rather than exchanges.

Understanding Interest Rate Swaps

Interest rate swaps are used by companies to manage interest rate risk. They allow companies to exchange fixed interest rate payments for floating interest rate payments, or vice versa, to better align with their financial strategies. These types of swaps are known as plain vanilla swaps. If two floating rates as involved in the swap, it is known as a basis swap.

How Does an Interest Rate Swap Work?

In an interest rate swap, one party agrees to pay a fixed interest rate while receiving a floating interest rate from the other party. The floating rate is typically tied to a benchmark such as IBOR (Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate). The payments are made periodically, and the notional value is used to calculate the interest payments. The swaps will begin with a value of zero but then will move in value according to interest rate changes.

Types of Interest Rate Swaps

There are several types of interest rate swaps, including:

Fixed-for-Floating Swaps

Fixed-for-floating swaps are the most common type of interest rate swap. In this type of swap, one counterparty, called the payer, pays a fixed interest rate, and receives a floating (or variable) interest rate in return. While the other counterparty, called the receiver, receives the fixed rate and pays the floating rate. Instead, of terms like ‘buyer’ and ‘seller’, we use the terms ‘payer’ and ‘receiver’, which describe who is paying or receiving the fixed leg. These are known as plain vanilla swaps.

Basis Swaps

Basis swaps are where both parties exchange floating interest rates, but these rates are based on different benchmarks. This can help mitigate currency risk or other market movements such as indices. Basis swaps are often used in energy trading where a commodity index such as oil or gas is one of the legs.

Fixed Interest Rate vs. Floating Interest Rate

• Fixed interest rate: the interest rate remains constant throughout the life of the swap
• Floating interest rate: the interest rate fluctuates based on a benchmark such as IBOR, SOFR or it can be energy or commodity indices

What are the Pros and Cons of Interest Rate Swaps?

Interest rate swaps are useful forward contracts are useful instruments to manage expectations for market conditions. Here are the highlights for Pros and Cons of their usage:

Pros

• Risk management: helps companies manage interest rate risk which is particularly useful for international trade or if raw materials are denominated in different currencies
• Offers flexibility: IRS trade over-the-counter and are fully customizable terms to meet specific needs in terms of size, legs and length of the swap
• Potentially save money: using swaps and other financial instruments is designed to save money (primarily interest rate costs) and well as assist with the financial planning and cash flows of the corporation

Cons

• Creates complexity: using interest rate swaps requires understanding of financial markets and instruments, as well as the risks involved in contracts
• Counterparty risk: as with all trading there is the potential for default by the other party which can put the swap holder at risk – the swap is typically cancelled in the event of a default and the non-defaulting party will seek compensation for any losses
• Can be costly: if the economic outlook changes or other (internal or external) events take place what weren’t factored into the swap expectations then it can be a costly exercise for corporations and banks

Interest Rate Swap Terminology

Here are some common terminologies in interest rate swap:

What is the ‘Value’ of an Interest Rate Swap?

The value of an interest rate swap is determined by the present value of the fixed and floating legs. At inception, the present value is typically zero, meaning the value of the fixed and floating legs are equal and opposite.

What is the ‘Notional Value’ in an Interest Rate Swap?

The notional value is the amount used to calculate interest payments on both legs of the swap. It is not exchanged at inception but is used as the basis for determining the interest cash flows.

What is the ‘Term’ in an Interest Rate Swap?

The is the length of the swap agreement as agreed by both parties, typically this ranges from 1 years to 15 years.

What is ‘Payment Frequency’ in an Interest Rate Swap?

Payment frequency refers to how often interest payments are made on either leg of the swap. Both parties must agree on this frequency, and common intervals include quarterly, semi-annual, or annual payments.

What is ‘Reset Frequency’ in an Interest Rate Swap?

Reset frequency indicates how often the floating interest rate is reset. This affects how often the floating rate adjusts to reflect current market conditions. For example, in a swap tied to an overnight risk-free rate (RFR) like SOFR, the rate is reset daily.

What is the ‘Maturity Date’ in an Interest Rate Swap?

The maturity date is the final date on which payments will be made, after which the contract terminates. It marks the end of the swap agreement and an end to interest payments on both legs.

What is ‘Netting’ in an Interest Rate Swap?

Netting is part of the broader master agreement (such as the ISDA) and is not agreed upon on a trade-by-trade basis. Opposing cash flows due on the same day are offset against one another, so only the net amount is paid by one party. This reduces operational complexity and minimizes counterparty risk by lowering the total cash exchanged.

What is ‘Over-The-Counter’?

In the context of financial instruments, “over-the-counter” (OTC) refers to trades that are conducted directly between two parties, outside of formal exchanges. OTC instruments, such as interest rate swaps, allow for full customization of trade details and key features, which must be agreed upon at the time of the trade.

What is ‘SOFR’?

SOFR is the Secured Overnight Financing Rate which is essentially the overnight rate that banks can borrow cash in the US. It is based on the transactions in the US Treasury repurchase market and is a key benchmark for interest rate swaps. This rate has replaced LIBOR and uses actual transactions rather than bank estimates.

Example of an Interest Rate Swap

A company with a variable-rate loan might enter into a fixed-for-floating interest rate swap to lock in a fixed interest rate. This helps the company manage its interest rate risk by stabilizing its interest payments.

For instance, if the company has a loan with a floating interest rate tied to the Interbank Offered Rate (IBOR), they might swap this for a fixed interest rate of 5%. This means the company will pay a fixed rate of 5% while receiving payments based on the floating IBOR rate.

Here is an example of an IRS:

As the company is seeking a fixed rate, it will be paying for the fixed rate on the swap. In this example it is the Offer they will be paying (4.07%), and the market maker is willing to receive the fixed rate. The total all-in rate that will be paid is 4.07% + 2.25% = 6.32%.

To work through another example of interest rate swaps download the free Financial Edge template in the free downloads section:

The Excel template walks you through identifying the correct leg for each swap party, calculating payment days and the interest owed by both parties.

Conclusion

Interest rate swaps are essential financial instruments that allow companies to manage interest rate risk by exchanging fixed and floating interest rate payments. These swaps provide flexibility and risk management benefits, although they come with complexities and counterparty risks. Overall, interest rate swaps are valuable tools for aligning financial strategies and stabilizing interest payments.