Interest Rate swaps (IRS)

In simple words interest rate swaps can be thought of as the exchange of interest rates of a specific principal amount. Interest rate swaps are generally used to convert floating rate of interest to fixed and vice versa. A company usually swaps interest to mitigate risk or to obtain lower rate of interest.

Interest rate swaps can be used for both; speculative and hedging purpose. Swap of interest can be between different interest scheme; fixed and floating or for similar interest payment schemes. The most common and widely used type of interest rate swap is between floating and fixed interest rates which is widely called as vanilla swap.

Interest rate swap function is done by financial institutions or banks with very good credit rating and has function as market makers. They charge certain fees for these services. There are no geographical restrictions and the swaps can occur between parties from other countries. Interest rate swaps generally occur for huge amounts. This will allow the parties to get cheaper rate of interest rates at the country where they would be foreigners and would cost more to borrow. The base for the swap is made such that they are each other’s equivalent in terms of value.

Example:

If Abhay wants to expand his business to the United States of America and a US based company wants to set up a factory in India then they can have a interest rate swap and each get capital at a lower rate.

Working of Interest Rate Swaps

There are two companies say; A and B. Company A has a fixed rate of interest of 8% per year and Company A has a floating rate of interest at (*MIBOR+2%).The amount borrowed by both the companies is ₹ 10, 00,000 each from different lenders.

Year 1

So let’s say that the MIBOR at the end of 1 st year was 4%.

Then Company A would pay 8% of interest amounting to ₹80,000 as interest and Company b would pay (4+2)% =8% of interest amounting to ₹60,000.

Year 2

Let’s say in the second year MIBOR is 7% then Company B would still be paying ₹80,000 and Company A would have to pay 9% of interest amounting to ₹90,000.

Company A and B both are not happy with the situation and hence decide to swap interest rates with each other as those rates.Company A feels it would be better off with a floating rate of interest whereas company B feels more comfortable having a fixed rate. The process of cancelling the loan with their current lender and getting a loan can be a time consuming and costly process so they would rather swap their interest rates.So we consider that Company A and B exchange a notional(only for make sake) ₹10,00,000. Further Company A agrees to pay a floating rate of MIBOR+1% and company B agrees to pay a fixed rate of 7%.After the swap the situation would differ as follows:

Year 1

Company A will pay interest of ₹80,000 to his lender and would pay MIBOR(4%)+1%=5% amounting to ₹50,000 and in return would receive ₹70,000 from B. Company A would pay a net of 80,000+50,000-70,000 = ₹60,000

Company B would pay interest of 60,000 to the lender and pay ₹70,000 to Company A and receive ₹50,000 from company A. Company B would pay a net of 60,000+70,000-50,000= ₹80,000.

Year 2

Likewise Company B would pay ₹90,000 and Company would pay ₹80,000 in the second year. The companies have swapped their interest rates and hence got schemes that better fit their requirements.This is how interest rates are swapped.

*MIBOR=Mumbai Inter Bank Offer Rate

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