Over the recent years, the volatility of interest rates has resulted in many issues for companies that have assets and liabilities who do not match in maturity. For instance, many companies have fixed rate assets that are long term, while they have liabilities that are short term. Whenever the market causes interest rates to rise, these companies experience lower earnings because their assets don’t yield as much as the cost of borrowing does.
Because of these problems, many companies search for ways to reduce their exposure in the market to fluctuations in interest rates. While many options are available to them, such as buying futures or refinancing their debt, many turn to interest rate swaps.
Why is this? What makes rate swaps so popular and in demand? Why do so many companies choose to take advantage of these derivatives instead of other hedging techniques?
In order to answer these questions, we need to first discuss exactly what interest rate swaps are and what benefits they offer.
Introduction and Benefits of Swaps
Interest rate swaps usually occur two private parties who want to minimize their exposure to fluctuations in the market. However, these two parties generally want to achieve opposite goals because they have different problems. One may have long term assets at a fixed rate and short term liability, while the other may have short term assets at a floating rate and long term liability. When they enter into a swap, they can exchange these interest rates, so the first can obtain a floating rate on their assets and the second can obtain a fixed rate.
If the two parties agree to exchange interest rates and make interest payment to one another, they can alter their exposure to fluctuations. However, because the interest payments are made to one party from another, the swaps don’t appear on a company’s balance sheet and no money is loaned. This exchange simply allows them to change the amount of risk implied on their balance sheet.
So, other than reducing the amount of risk a company experiences, what are some of the main advantages of using these types of exchanges, rather than other derivatives available?
- Cost – While it might seem like refinancing your debt would be a much easier task to accomplish when you need to adjust your exposure, it isn’t always best to take the easy way out. Depending on your credit and your company’s age, refinancing could mean you actually experience an increase in the interest you are expected to pay on your loan. On top of this cost, you may also have to pay legal fees, regulatory restriction fees, and advertising costs. Because rate swaps don’t involve borrowing new and more money, you don’t have to worry about paying more. In fact, the exchange of interest most often means you will be paying less.
- Flexibility – When you refinance, the market you can obtain a loan in is limited, and many times, you will not have a comparative advantage in them. With interest rate swaps, however, you can take advantage of several different markets and several different currencies to find an interest rate that works best for you.
- Profit – If you decide to refinance, and are hit with a larger amount of interest you must pay each month, you may not be able to take that new loan and actually make a profit. With an exchange of interest, however, you can ensure that you are choosing the best rate for yourself so you can remain profitable while reducing your exposure in the market.