Introduction
When organisations take on debt, the fluctuation in interest rates can greatly affect their expenses. To navigate this risk, many businesses look to a financial tool known as an Interest Rate Swap (IRS). At first glance, it might seem complicated, but an IRS is really just a simple agreement between two parties to swap interest payments. Read on to know more.
What is an Interest Rate Swap
It’s a financial tool that allows parties to exchange one type of interest rate for another. This method can help mitigate the risks related to fluctuating interest rates or to get a more attractive rate. This exchange involves converting fixed-rate payments to floating rates or vice versa. This swap is typically decided upon for a specific time period.
Companies frequently tailor these swaps to match their own financial needs, making them an attractive choice for maximising cash flow.
How Does Interest Rate Swaps Work
Upon establishing the swap contract, the total fixed interest rate amount is viewed as equivalent to the anticipated cash flow from the floating interest rate. It's important to note that floating interest rates can vary significantly, and this variability may lead to potential losses for those receiving cash flow. In the event that an interest rate swap turns out to be unprofitable, the counterparty has the option to engage in countervailing swaps to mitigate the interest rate risk associated with the original swap.
Types of Interest Rate Swaps
Before we look at the types of IRS, it is important to understand that MIBOR, or Mumbai Interbank Offered Rate. It is a standard that reflects the interest rate at which Indian banks loan unsecured funds to one another in the interbank lending market. It is used as a benchmark for evaluating various Indian securities and indicates the liquidity and general wellness of the money market in the country.
Here are the three common types of IRS:
Fixed-to-floating
In a fixed-to-floating interest rate swap, a customer engages in a contract where they receive cash flow based on a fixed interest rate while making payments that fluctuate with floating interest rates. Interest is determined based on a set principal amount that has been established beforehand. Floating interest rates are linked to the MIBOR benchmark, which is established on a daily basis.
Floating-to-fixed
In a floating-to-fixed interest rate swap, a customer engages in a contract where they receive cash flow based on floating interest rates while making payments at fixed interest rates. This arrangement allows for a strategic approach to managing interest rate exposure. Once more, the calculation of interest is based on a designated principal amount.
Float-to-float
In a float-to-float interest rate swap, companies engage in a contract where they exchange payments on a designated principal amount. These payments are determined by floating rates that reference two distinct benchmarks. This financial arrangement allows for flexibility in interest rate management. Companies have the option to utilise float-to-float interest swaps as a strategy to adjust the tenure or type of floating-rate index, allowing them to secure more appealing rates.
What does Interest Rate Swap Help With?
An IRS can help a business with the following:
- Reducing Risk: When a company takes out funds at a floating rate, an increase in the rate of interest can lead to higher loan costs.
- Cost Saving: Adjusting loan structure can save organisations money compared to taking out a new loan with desired terms.
- Flexibility: An IRS enables businesses to align their liabilities with their cash flow requirements.
Real Life Interest Rate Swap Example
Let’s consider Agency XYZ, a high flying firm in the financial capital of the country. The agency got a loan of ₹100 Cr with a floating interest rate set at MIBOR plus an additional 2%. They were concerned that an increase in interest rates could lead to a heavier repayment burden.
To tackle this risk, it engages in an Interest Rate Swap with Bank ABC.
According to the agreement, Agency XYZ is set to pay a fixed 7% interest to the bank.
Agency XYZ is set to receive a floating rate from Bank ABC, which is calculated as MIBOR plus an additional 2%, based on a notional amount of ₹100 crore.
Understanding the process:
In the event that MIBOR increases, Agency XYZ has a safeguard in place, as it is committed to a fixed payment of just 7% to the bank.
When MIBOR declines, Agency XYZ might miss out on the opportunity to take advantage of reduced rates. However, this shift brings a sense of stability and predictability to its costs.
This approach allows the company to enhance its financial planning, particularly in times of fluctuating interest rates.
Conclusion
Interest rate swaps let parties exchange interest payments between one another. This strategy can help manage interest rate risks or lock in better borrowing conditions. Companies use interest rate swaps to manage interest rate fluctuations, and take advantage of market situations and align their cash flows with their financial strategies by doing so.