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Interest rate risk management

INTEREST RATE SWAP

The interest rate swap is a contract between two parties to exchange interest payments in one currency for a period of time fixed in advance.

The amount of the exchanged interest payments depends on the amount of the principal sum negotiated and the level of interest rates during the life of the contract. The principal is not exchanged.

What is the rationale of the interest rate swap and who needs it?

Example: A client has been granted a credit in Euros at a floating interest rate, let's say EURIBOR + 3%. The floating component here is the EURIBOR. The client anticipates that the interest rates in the Euro zone will be rising. In this case his interest payments will increase. How could he avoid it? By striking an interest rate swap deal.

What happens in an interest rate swap?

What really happens is that the party paying the floating interest rate can exchange the floating component for a fixed one. He thus is able to avoid paying possible additional interest in the event the EURIBOR rises.

What does the client do if he decides to use such a swap?

In our example the client can decide to use an interest rate swap. He calls the dealers and makes arrangements for an appointment to negotiate a fixed rate in exchange for the floating rate. Both parties then agree to fix the floating component (the EURIBOR) at 3%. This means that the fixed interest payable by the client will be 3 + 3 = 6%. If the EURIBOR should rise above 3%, the client then receives a positive net interest cash flow and is protected from the adverse interest rate movements.

What is the result of the interest rate swap for the client?

1). By using an IRS the client effectively manages his interest rate risk exposure during the term of the credit;
2). The client can quite precisely budget his future interest payments because the interest rate fluctuations cannot surprise him.