What it means
The notional amount is the reference figure used to calculate payments, not money that anyone actually lends. If two parties swap on $10,000,000 notional, they never exchange that sum; they simply work out what each side owes on it and settle the net difference.
The usual motive is turning uncertainty into a budget line. A company with a floating rate loan cannot forecast next year's interest, so it agrees to pay a fixed rate and receive floating, and the floating leg it receives offsets the floating rate it pays its lender.
The result is a synthetic fixed rate loan. The company's all in cost becomes the swap's fixed rate plus whatever margin the lender charges over the benchmark, regardless of where the benchmark itself ends up.
Swaps carry risks of their own. The counterparty might fail, the swap has a market value that swings with interest rates and has to be shown in the accounts, and if the underlying loan is repaid early the swap does not politely disappear with it.
Breaking a swap costs real money. If rates have fallen since the swap was agreed, the fixed payer is locked into an above market rate and must pay the mark to market value to exit, which is why the swap's term and amount should track the loan it is meant to hedge.
In practice
Real-world examples.
Example
A property investor borrows $25,000,000 on a floating rate to buy an office block let on ten year leases. Because the rental income is effectively fixed, the investor swaps into a fixed rate so that income and interest cost move together rather than drifting apart.
Example
A highly rated corporate can borrow cheaply at a fixed rate but prefers floating exposure. It issues a fixed rate bond and then enters a swap to receive fixed and pay floating, ending up with a floating cost below what it could have borrowed at directly.
Example
A manufacturer repays a hedged loan two years early after a strong trading period. Interest rates have fallen since the swap was agreed, so unwinding the contract costs $310,000, an expense the board had never built into its early repayment plan.
Formula
Calculation
Net settlement to the fixed payer = notional x (floating rate - fixed rate) x days in period / days in year
All in cost of a hedged floating loan = swap fixed rate + lender's margin over the benchmark
A company borrows $10,000,000 at the benchmark rate plus 1.20% and enters a swap on the same $10,000,000 notional, paying 4.00% fixed and receiving the benchmark, settled once a year.
Suppose the benchmark sets at 5.20%. The loan costs $10,000,000 x (5.20% + 1.20%) = $640,000. On the swap the company pays $10,000,000 x 4.00% = $400,000 and receives $10,000,000 x 5.20% = $520,000, a net receipt of $120,000, so total cost is $640,000 - $120,000 = $520,000.
Now suppose the benchmark sets at 3.10% instead. The loan costs $10,000,000 x (3.10% + 1.20%) = $430,000, and the swap costs the company $400,000 - $310,000 = $90,000 net. Total cost is $430,000 + $90,000 = $520,000 again, which is 5.20% of the notional, exactly the 4.00% fixed rate plus the 1.20% lending margin.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Estridge Hotels, an invented chain of eight properties, borrowed $40,000,000 on a floating rate of benchmark plus 1.50% and calculated that a one point move in rates would change its annual interest by $40,000,000 x 1% = $400,000, enough to swing the group from profit to loss.
It entered a five year fixed-for-floating swap on $30,000,000 of the debt, paying 3.80% fixed and receiving the benchmark. That fixed the cost on three quarters of the borrowing at 3.80% + 1.50% = 5.30%, or $30,000,000 x 5.30% = $1,590,000 a year, while leaving $10,000,000 floating so the group would still gain something if rates fell.
When the benchmark climbed to 6%, the unhedged $10,000,000 cost $10,000,000 x 7.50% = $750,000 while the swapped portion stayed at $1,590,000, giving total interest of $2,340,000 rather than the $40,000,000 x 7.50% = $3,000,000 the group would have paid unhedged. In this fictional scenario the swap saved $660,000 in a single year, though the board was careful to record that a fall in rates would have produced the mirror image.
Watch out
Common mistakes.
- Believing the notional amount is money at risk, when only the net interest difference is ever exchanged between the parties.
- Arranging a swap whose term or amount does not match the underlying loan, leaving the business hedged against debt it no longer has.
- Treating a swap as free insurance, when fixing a rate means giving up the benefit of any fall as well as the risk of a rise.
Questions
People also ask.
Who takes the other side of the swap?
Usually a bank running a book of offsetting positions, which quotes a fixed rate that already contains its own margin.
What does it cost to enter a swap?
There is normally no upfront fee, because the bank's margin is built into the fixed rate quoted, but exiting the contract early can be very expensive.
How does a swap appear in the accounts?
As a derivative carried at fair value, with hedge accounting available if the relationship is documented properly, which keeps the swings in its value out of the profit and loss account.
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