A percentage swap is a type of simple currency swap and its main difference is that not one money supply is exchanged for another, as in a simple swap, but interest payments from these amounts. An interest rate swap is the exchange of interest payments calculated from a certain amount over a predetermined time interval by exchanging a floating interest rate for a fixed rate.
It is during interest rate swap operations that a rather well-known concept in the world of finance is used: “LIBOR rate”. The LIBOR rate is a floating interest rate that is used in 99% of all interest rate swap transactions.
Example interest rate swap transaction:
- Company A has debt in the amount of USD 100 million;
- The debt repayment period is 5 years;
- The interest rate on the loan is floating and is reviewed once every 3 months;
- The interest rate for the current 3 months is 1.50%;
- The company is afraid of raising the key Fed rate, as this will lead to a rise in the cost of debt;
- The company, in order to hedge interest rate risk, concludes an interest rate swap contract with the bank;
- The bank will pay at a quarterly floating rate LIBOR of 0.2%;
The essence of the operation will be that the company will make payments at an annual rate of 1.50% each quarter. In exchange, the bank will pay based on the quarterly LIBOR rate. To reduce the overall credit risk, one of the parties will pay the difference between the size of payments.
Schematically, this operation will look like this:
If you calculate the amount of payments, the first payment will be calculated by the formula:
company payment – bank payment = (100 million * 0.015) / 4 – (100 million * 0.002) / 4 = 375,000 – 50,000 = 325,000 USD.
Now consider the payment for the next quarter: all parameters remain unchanged, except for the floating rate LIBOR, which has grown and now stands at 0.8%. Now the formula will look like this:
company payment – bank payment = (100 million * 0.015) / 4 – (100 million * 0.008) / 4 = 375,000 – 200,000 = 175,000 USD.
Now the difference between the first payment and the second is visible without any calculations.
Thus, if the floating interest rate swap rate increases, the company will receive benefits, otherwise the bank will receive benefits. After immersing himself in the process of this operation, the question arises: “why do such a deal be concluded by one of the parties. which may be disadvantageous in the future, because this is not about 100 USD? ” You will not believe it, but the laws and principles of concluding transactions by market movers are absolutely identical to the principles of opening positions on the exchange by simple private traders, namely: hope, expectation, and thirst for profit. The company hopes that even if the Fed raises the key rate, a floating rate will rise along with it, which will exceed expectations, and the bank considers itself “the smartest” and is confident that the rate will fall and this agreement with the company will be beneficial precisely his.