Interest-rate swaps: how does it work?

Why do companies buy interest-rate swaps?

• By buying interest-rate swaps companies are looking to keep a grip on their future interest cost, as business plans benefit from a stable cost base.

• Companies are at risk of rising interest rates on variable-rate loan agreements they’ve entered into.

• Companies can hedge these risks by taking on interest-rate swaps and so avoiding additional interest charges if and when variable interest rates go up.

How does it work?

• Interest-rate swaps are separate products that  are not directly linked to the original loans in respect of which the company wants to hedge the interest rate risk. That said, their purpose is to ensure stability of the interest paid on those loans..

• When agreeing on a interest-rate swap, the bank and the company trade variable and fixed rates. Under the interest rate swap the company receives from the banks the variable rate of interest it owns under its loan(s) excluding any variable mark-ups , and subsequently pays a fixed rate as agreed under the interest rate swap to the banks. This set-up protects companies from increases in interest rates.

• Note that companies still have to pay any variable mark-ups and that these are not covered by interest-rate swaps.

Why don’t companies just take out fixed-rate loans if they’re looking for certainty about their interest charges?

A fixed-rate loan is definitely a good alternative in order to fix interest charges. However, the choice between the type of loanwill depend on the  companies’ own preferences and might depend on the specific situations they are in. There are a number of reasons why companies prefer to   combine variable-rate loans and interest-rate swaps over fixed rate loans. To mention just a few:

• Interest-rate swaps offer greater flexibility, as companies can also use them for hedging interest rates on other loans they’ve taken out. In addition, companies can transfer interest-rate swaps to other banks if they agree variable-rate loans with them or renegotiate existing loans.

• Variable rates loans coupled with interest-rate swaps are often cheaper than fixed-rate loans.

Do companies incur additional costs when buying interest-rate swaps?

An interest-rate swap does not involve any extra costs for the company if the loan and its concomitant interest-rate swap both run until the agreed maturity date. Interest-rate swaps only involve extra charges if the following combination of factors occurs: 

• interest rates haven’t gone up but have rather fallen; and

• the company is looking to change or terminate the interest-rate swap before the maturity date.

When interest rates fall, interest-rate swaps will have negative values. This is not a problem if the swap runs until maturity, in which case its value will always be nil. But if an interest-rate swap is terminated or adjusted at a time it has a negative value, the company will incur a financial liability.

Do companies often terminate or change interest-rate swaps before maturity?

No, they don’t. 

Does this problem not arise for fixed-rate loans?

If a company wants to terminate or change a fixed-rate loan before maturity, it may incur additional costs. It may be charged penalty interest if, at the time of the change, interest rates are lower than the rate agreed under the loan. The penalty rate reflects the calculation of the negative value of an interest-rate swap if interest rates have fallen below the rate agreed in the interest-rate swap.

Do companies suffer from their interest-rate swaps’ negative values?

An interest-rate swap will only have a negative value if interest rates fall below the rate agreed in the interest-rate swap, and that will only be a problem if the company is looking to change or terminate the interest-rate swap before maturity. For an interest-rate swap that is not changed or terminated before maturity, the value of the swap – positive or negative – during the term to maturity is irrelevant, as it will always be nil at maturity. By that date, neither the company nor the bank will have any outstanding payment liability related to the interest-rate swap.