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Interest rate swaps that benefit both parties.

Interest Rate Swaps That Benefit Both Parties

In the early 1980s, the U.S. financial community created interest rate swaps, a remarkably innovative financial technique affording risk managers a degree of financial flexibility previously unavailable. Simply stated, interest rate swaps are an exchange of interest-rate payments between two parties without an exchange of the underlying debt.

Interest rate swaps have a broad range of applications including: unlocking a company's high-coupon debt (by swapping it for a lower-cost, floating-rate debt); capping the cost of floating-rate funds (by transforming such funds into fixed-rate money); changing a company's borrowing index from one base rate to another (by simply swapping base rates with another party); and closing a company's balance-sheet gap (by changing variable-rate money into fixed-rate money, or vice versa, depending upon the nature of the gap). Generally, when two parties have different asset yields, liability costs or asset/liability structures, they can benefit from an interest rate swap.

The Mechanics of Swaps

Interest rate swaps are easily arranged and simple to execute, which explains their explosive growth. The intermediary arranging the swap, usually a commercial or investment banker, pairs up two parties needing such services and charges a small commission (about .13 percent to .25 percent) for doing so. Since a swap is not tied to the assets or liabilities of either party, the credit risk of each party is limited to the payments to be received from the other party. If one party defaults, the other simply stops payment. If either party is nervous about the other's creditworthiness, protection guarantees such as escrow, collateral or letters of credit can easily be arranged.

A party can exit a swap agreement by letting it contractually expire or by mutually agreeing with the counterparty to terminate the agreement. If the counterparty is not amenable to prematurely terminating the contract, they can usually be monetarily induced to do so. Alternatively, if the amount of debt underlying the swap is significant, the swap agreement can be sold in the swap secondary market currently operated by investment banks and major commercial banks.

Generally, swaps are treated as off-balance-sheet items, mentioned in footnotes only if significant in size. On the income statement, swap payments flow through "other income/other expense." Currently, the Financial Accounting Standards Board does not have a formal opinion on interest rate swaps.

Applications

A common application of interest rate swaps is to lower the borrowing costs of both parties. Consider two hypothetical corporations: an AA-rated corporation which can borrow short-term at a floating rate of the T-bill rate plus 1 percent, and long-term at a fixed rate of 10 percent and a BBB-rated corporation which can borrow short-term at a floating rate of the T-bill rate plus 2 percent, and long-term at a fixed rate of 13 percent. By engaging in an interest rate swap, the BBB firm can lower its long-term borrowing rate, and the AA firm can lower its short-term borrowing rate.

The AA company borrows $X long-term at a cost of 10 percent; the BBB company borrows $X short-term at a cost of the T-bill rate plus 2 percent. The companies then enter into a swap agreement whereby the AA firm agrees to pay the T-bill rate plus .5 percent to the BBB firm, and the BBB firm agrees to pay 10.5 percent to the AA firm. As a result, the AA firm's net cost of short-term money is the T-bill rate, and the BBB firm's net cost of long-term money is 12 percent.

By entering into a swap agreement, both firms were able to reduce their borrowing costs by a full percentage point. For large sums of money, such reductions in borrowing rates translate into significant savings for both parties.

Economically, interest rate swaps are nothing more than the application of the principle of comparative advantage, originally derived by economist David Ricardo to explain international trade. Even though the AA firm has an absolute borrowing advantage in both the short-term and long-term markets, it has a comparative advantage in the long-term market. The 2 percent spread differential between the two markets (3 percent difference in long-term borrowing costs, less 1 percent difference in short-term borrowing costs) represents the potential savings for both parties. Thus, as long as different borrowers have different borrowing costs, both parties can economically benefit by engaging in a swap, regardless of the level or slope of the prevailing yield curve.

Risk managers can also use swaps to change variable-rate loans into fixed-rate loans, or vice versa. Assuming the BBB firm's short-term loan was at a floating rate and the AA firm's long-term loan was at a fixed rate, the BBB firm's variable-rate loan was effectively transformed into a fixed-rate loan, and the AA company's fixed-rate loan was effectively transformed into a variable-rate loan.

Consider how a risk manager could use interest rate swaps to change a company's asset structure and increase its asset yields. Suppose a company has $Y in AA-quality, floating-rate securities which pay the 13-week T-bill rate plus 70 basis points. Suppose also that the firm would like to convert these securities into a fixed-rate, fixed maturity yield but prefers not to sell them outright for reasons such as capital losses commission costs. If this company could be matched with a counterparty who wants to temporarily convert fixed-rate, fixed-maturity notes into floating-rate securities, both parties could effectively swap yields via an interest rate swap.

The firm pays the T-bill rate plus 40 basis points to a counterparty, and the counterparty pays the current AA yield to the firm. The counterparty has effectively converted its securities into floating-rate notes, and the company has effectively obtained a fixed-rate, fixed-maturity yield for the life of the swap (which can always, of course, be renewed). Notice also that the client is earning 30 points more than the current AA rate, a yield pickup made possible by linking two parties whose assets have different returns.

Russ Ray is associate professor of finance in the School of Business at the University of Louisville.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

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Author:Ray, Russ
Publication:Risk Management
Date:Apr 1, 1989
Words:1004
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