Interest Rate Swap
What it is:
An interest rateis a contractual agreement between two parties to exchange interest payments.
How it works/Example:
The most common type of interest ratereference rate (in almost all cases, the London Interbank Offered Rate, or LIBOR).
For example, assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes.
Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month. The payment she receives never changes.
Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rate swap contract.
Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1,000,000 principal amount (called the "notional principal" or "notional amount"). Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.
Let's see what this deal looks like under different scenarios.
Scenario A: LIBOR = 0.25%
Charlie receives a monthly payment of $12,500 from his investment ($1,000,000 x (0.25% + 1%)). Sandy receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).
Now, under the terms of the swap agreement, Charlie owes Sandy $12,500 ($1,000,000 x LIBOR+1%) , and she owes him $15,000 ($1,000,000 x 1.5%). The two transactions partially offset each other and Sandy owes Charlie the difference: $2,500.
Scenario B: LIBOR = 1.0%
Now, with LIBOR at 1%, Charlie receives a monthly payment of $20,000 from his investment ($1,00,000 x (1% + 1%)). Sandy still receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).
With LIBOR at 1%, Charlie is obligated under the terms of the swap to pay Sandy $20,000 ($1,000,000 x LIBOR+1%), and Sandy still has to pay Charlie $15,000. The two transactions partially offset each other and now Charlie owes Sandy the difference between swap interest payments: $5,000.
Note that the interest rate swap has allowed Charlie to himself a $15,000 payout; if LIBOR is low, Sandy will owe him under the swap, but if LIBOR is higher, he will owe Sandy money. Either way, he has locked in a 1.5% monthly return on his investment.
Sandy has exposed herself to variation in her monthly returns. Under Scenario A, she made 1.25% after paying Charlie $2,500, but under Scenario B she made 2% after Charlie paid her an additional $5,000. Charlie was able to transfer the risk of interest rate fluctuations to Sandy, who agreed to assume that risk for the potential for higher returns.
One more thing to note is that in an interest rate swap, the parties never exchange the principal amounts. On the payment date, it is only the difference between the fixed and variable interest amounts that is paid; there is no exchange of the full interest amounts.
Why it matters:
Interest rate swaps provide a way for businesses to hedge their exposure to changes in interest rates. If a company believes long-term interest rates are likely to rise, it can hedge its exposure to interest rate changes by exchanging its floating rate payments for fixed rate payments.