Interest Rate Swaps

Interest rate swaps are a trading of interest based cash-flows. To illustrate an interest rate swap, if Company A has an initial floating interest rate of 5 percent on a $10,000 investment but prefers to have a fixed interest rate while still owning the investment, it can trade with another company that prefers a floating rate. This kind of transaction is called a plain vanilla swap per Natalie Moyen, Associate Professor of Finance at the University of Colorado.

When a plain vanilla swap exchange first occurs the swap is generally not profitable for either company; however, if the the variable rate changes one of the companies financial position improves. For example, if the variable rate drops to 4 percent, interest rate risk has effectively been avoided by Company A all other variables held constant. Also according to Moyen, negative cash-flows in the form of debt obligations can be traded for similar reasons i.e. to avoid increases in debt payment or potentially reduce debt obligations.

Fixed interest rate swaps may also be profitable if the exchange is made in competing currencies. To illustrate, if company a exchanges a cash-flow on $100,000 at 7 percent in U.S. Dollars with company B’s cash-flow on the Euro equivalent of $100,000 at 7 percent, company A will profit if Company B’s currency increases in value over the dollar.

Moreover, $100,000 at an exchange rate of .68 will require company B’s initial equivalent currency investment to be valued at €68,000 and €4,760 at a 7 percent interest rate. If that exchange rate becomes .55 but the initial investment doesn’t change, then the interest cash-flow on that investment rises in value even though the original investment on which the cash-flow is based stays the same. In other words, when €4,760 is converted into dollars on day 1 it is equal to $7,000, but when the Euro strengthens against the dollar by .13 that same €4,760 becomes $8,654.54.

Interest rate swaps can be used to protect a company against what is known as currency risk as evident in the previous example. Moreover, if a company is concerned about the value of its investment in terms of import costs, it can hedge against this risk with a fixed interest rate swap. However, for this swap to effectively protect against currency risk the incoming cash-flow must increase in value over the outgoing cash-flow creating an element of risk as floating exchange rates generally cannot be predicted with 100 percent accuracy.

Several types of interest rates swaps exist. In the first example above, a plain vanilla swap took place. These are interest rate swaps that exchange a fixed for floating interest rate. The second example was  a currency swap because the interest rates and principle investment were fixed but the exchange rate was floating.

In the book ‘Modern Commercial Banking’, Economist H.R. Machiraju describes additional swaps called base swaps and rate capped swaps. According to Machiraju, base swaps exchange floating rates of interest rather than fixed only or a combination of fixed and floating, and rate capped swaps place limits on how high a floating rate can change before the interest rate based cash-flow can no longer increase or decrease in value.