What it means
Imagine a company with a $10,000,000 loan whose interest rate changes every few months. If market rates rise, its interest bill rises too, which makes budgeting hard.
The company can enter a swap with a bank to pay a fixed rate and receive a floating rate, so that the floating payments on the loan are offset. The notional amount is the figure on which the interest payments are calculated, and it is never actually exchanged.
The two sides swap interest payments, usually every quarter or six months, and in practice only the net difference changes hands. This keeps the cash flows small compared with the notional amount.
The fixed rate is agreed on the first day and stays the same for the life of the swap. The floating rate is linked to a published benchmark rate, which is reset at regular intervals.
The swap is set up so that, at the start, it has no value to either side. Companies use plain vanilla swaps for protection against interest rate changes.
A borrower with a floating-rate loan can pay fixed on a swap to lock in its cost, while an investor with a fixed-rate asset might do the reverse. Banks act as the counterparty, often making money on a small margin built into the rate.
The swap is a separate contract from the loan. If the borrower pays fixed and receives floating, the floating receipt cancels the floating charge on the loan, and the borrower is left paying the fixed rate.
The company still owes the lender and also faces the risk that the swap bank cannot pay. Swaps change in value as rates move.
If market rates rise after the swap starts, the party paying fixed gains, and if rates fall, that party loses. These changes are recorded in the accounts, and hedge accounting rules may allow them to be matched with the loan, provided the documentation is right.
In practice
Real-world examples.
Example
A property developer has a $25,000,000 floating-rate construction loan and fears rising rates. It enters a five-year swap to pay a fixed rate and receive the floating rate. Its interest cost is now fixed and easy to budget.
Example
A utility company has issued fixed-rate bonds but believes rates will fall. It enters a swap to receive fixed and pay floating on $100,000,000. If rates do fall, its interest cost decreases.
Example
A school group with a floating-rate loan uses a swap to fix its cost over the next ten years. The finance committee sees the swap as insurance and not as a bet. It requires that the notional amount never exceed the loan balance.
Formula
Calculation
Net amount received by the fixed-rate payer = notional amount x (floating rate - fixed rate) x period fraction
A company has a $10,000,000 floating-rate loan and enters a swap to pay a fixed 4% and receive the floating rate. Over a year, the floating rate averages 3%. The fixed payment is $10,000,000 x 4% = $400,000, and the floating receipt is $10,000,000 x 3% = $300,000.
The net payment from the company to the bank is $400,000 - $300,000 = $100,000. If the floating rate had instead been 5%, the company would receive $500,000 and pay $400,000, a net receipt of $100,000, which offsets the higher interest on its loan.Case study
Seen in the real world.
Brackenfield Hotels is a fictional hotel chain, and this case is illustrative. It had a $40,000,000 floating-rate loan and found that a rise of one percentage point in rates would add $400,000 a year to its interest cost.
The finance director arranged a plain vanilla swap in which the company paid a fixed 4.5% and received the floating rate on a $40,000,000 notional amount. Rates rose by two percentage points over the next two years, and the swap payments from the bank offset the extra interest on the loan.
The company's interest cost stayed near 4.5% plus the loan margin, which let it keep to its budget. If rates had fallen, it would have paid more than the market rate, which the board accepted as the price of certainty. The illustrative lesson is that a swap trades possible gains for protection.
Watch out
Common mistakes.
- Thinking the notional amount is borrowed or paid, when it is only used to calculate interest.
- Assuming the swap removes all risk, when the company still faces counterparty risk and changes in the swap's value.
- Entering a swap larger than the underlying loan, which turns protection into speculation.
Questions
People also ask.
What does the fixed-rate payer receive?
It receives the floating rate, which offsets the floating interest on its loan.
Can a swap be cancelled early?
Yes, but it may require a payment to the bank if the swap has a negative value at that time.
Why is it called plain vanilla?
Because it is the standard, simplest design of an interest rate swap, with no special features.
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