Rate swaps are agreements made between two specific parties that allow these parties to exchange one interest rate for another. For instance, many companies can use this type of swap to exchange a fixed payment for one that is floating. Most companies use this type of swap to reduce their exposure to fluctuations in the market or to obtain lower interest rates.
There are many other reasons, however, why this tool might be used. In the following we are going to discuss several reasons interest rate swaps are utilized by companies every single day.
Why Interest Swaps Are Used
- Risk – One of the most beneficial uses of rate swaps for companies is their ability to hedge risk. When a company wants to avoid risk with their interest rates, they exchange the interest rate. This can greatly impact their overall cost, as the variances in different interest rates can produce a significant impact.
- Cost – Many large companies use interest rate swaps to lower their costs. They can not only lower the amount of interest they must pay for certain assets, but can also avoid paying fees that are often associated with other types of debt.
- Profits – The main purpose of most big businesses is to make money. However, with a fixed rate of interest and a fixed cash outflow, sometimes businesses have trouble staying out of the red. When companies are allowed to use swaps, they can choose to swap that fixed interest rate out for a variable rate, which can either increase or decrease. If the rate increases, but the cash outflow still remains the same, the swap is actually profitable for the business, and they are able to stay out of the red.
- Debt – While rate swaps can be profitable on their own, they can also offset and optimize debt in the same manner. Let’s say a company has a variable rate and a fixed amount of debt. If the floating rate is too high, they may have to continually borrow funds to cover their interest. By exchanging the unpredictable rate for a lower, fixed rate, they can actually afford their debt and the rate has the potential to actually be profitable.
How These Swaps Are Used
When two parties agree to swap interest, for any of the specific reasons listed above, they typically use the most common type of swap: the plain vanilla swap. This type of derivative involves the exchange of two cash flows in the same currency that are paid either annually, monthly, quarterly, or at specific intervals both parties agree on.
With this type of swap, one floating rate is exchanged for a fixed rate for a certain period of time. This time varies, depending on the agreement between the two parties. The amount of interest exchange also varies, although most investors use LIBOR, or the London Interbank Offer Rate, as a base for the variable rate. This is the typically rate of interest used by banks in London when deposits from Eurodollar market banks make deposits.
If you are considering an interest rate swap, consider how these derivatives could benefit you. Will they help you stay out of the red, reduce costs, manage debt, or manage risk in the market? If so, you should consider using rate swaps in the future.