Interest Rate SWAP

Sujata Sharma
Batch 2018-20

The term SWAP literally means an exchange. A derivative or financial Swap may be defined as
a contract whereby counterparties, exchange two stream of cash flow over a defined period of
time, usually through an intermediary like financial institution. The nature of the cash flow to be
exchanged is defined in the contract.

There are basically two major type of Swap structures- Interest rate swaps (IRS) and currency
swaps.

An interest rate swap (IRS) is a contractual agreement between counterparties to exchange a

series of interest payment for a stated period of time whereas a currency swap is a contractual
agreement between counter[parties in which one party makes a payment in one currency and the
other party makes payment in different currency for a stated period of time.

In this article we will be particularly talking about the Interest Swap rates.

Let’s take an example to understand better that how two companies helps each other lower their
borrowing costs through a swap agreement. Let’s consider two companies A & B that wants to
borrow a million dollars each for a five year period with annual compounding and they want to
borrow at the lowest possible rate.

Company A Company B
Credit rating A B
Fixed rate 6% 8%
Floating rate LIBOR +1% LIBOR +1.5%

Company A expects interest rates to decline in the future and therefore wants floating rates
borrowing while company B expects interest rates to rise and wants to lock in fixed rate available
to it although company a wants to borrow at a floating rate it plans to borrow at a fixed rate and
then swap its cash flow with company B that wants to do the opposite in the process both
companies intend to lower the borrowing costs and wind up with the type of borrowing they’ve
wanted at the first place. This is very typical of an interest rate swap where two parties with
opposite needs make an agreement to swap future cash flow. Let’s look at the rates in restless
expect the two companies to pay company A has a credit rating of A and this annual fixed rate of
borrowing is 6% whereas this is floating rate of borrowing is LIBOR+1%, Company B on the
other hand has a credit rating of B therefore annual fixed rate of borrowing is 8% whereas its.
floating rate of borrowing is LIBOR +1.5%. When we compare the fixed rates of the two
companies we notice that the company A pays 2% is lower or has an absolute advantage of 2%
over company being when we compare the floating rate of the two companies we notice that
company pays 0.5% lower or has an absolute advantage of 0.5%. In other words the investors
want company B to pay 2% risk premium over company A at the fixed rate but only 0.5% risk
premium at the floating rates. Thus, when we compare the two risk premiums Company B has a
competitive advantage if it borrows at the floating rate, had risk premium at both the rates being
same Company B would not have a competitive advantage. The competitive advantage creates
an arbitrage possibility of 1.5% when both companies borrow independently and enter into
swap agreement the two companies can then split the 1.5% and the proportion they agree upon.