The interest rate swap – also called IRS – is a contract with a financial broker in order to hedge changes in interest rates.
A swap allows the person who borrows a loan to transform floating-rate payments into fixed-rate payments and vice versa.
Premiums do not have to be paid in advance at the signing of the swap contract, as is the case with “options” (i.e. put or call) and in the case of “CAP”.
Example
If we have a 100,000 euro floating-rate loan with maturity of five years with variable interest calculated at 3 month EURIBOR plus a margin of 2%, and we enter into a swap with a third party, we know with certainty that we will pay a fixed rate for the duration of the loan.
Amount of funding: € 100,000
Financing rate: 3 month Euribor +2% margin
3 Month Euribor rate: 0.3%
Fixed rate swaps: 1.3%%
Let’s see what happens after 1 year.
If the 3 month Euribor rate rose to 1.5%, and if I have made the swap, I am in a favourable position, I pay less interest.
Let’s see how.
The company receives the Euribor rate (€ 1,500 – 1.5%), pays interest rate swaps (-1,300 euro – 1.3%) and pays interest due to the loan agreement (Euribor +2% or EUR 3,500).
Without the swap contract, the company would suffer financing interest equal to: 3 Month Euribor (1.5%) + 2% = 3.5% or € 3,500.
After another one year Euribor fell to 0.8%, in this case if you have entered into swap contracts are in a disadvantaged position. In fact, you will pay more and 3,300 (net balance of payments), instead of 2,800 if you had kept the floating rate loan without entering into the swap.
After another one year Euribor fell to 0.8%, in this case if you have entered into swap contracts are in a disadvantaged position. In fact, you will pay more and 3,300 (net balance of payments), instead of 2,800 if you had kept the floating rate loan without entering into the swap.
In conclusion, the advantages of the swap are:
• Allows you to fix the costs of financing
• It ’s an widely used and inexpensive instrument comported to other derivatives
• Do not require for an initial outlay (commission) as in the case of “options”.
Disadvantage of the swap:
• Do not allow to benefit from the reduction in interest rates.
