Interest rate swap (IR swap)
For businesses that are looking for long-term interest rate hedging, IR swaps may be a suitable choice.
What is an IR swap?
An IR swap is an agreement between two parties to swap interest rates on loans in the same currency. The swap involves one party swapping their variable rate for a fixed rate, while the other party gets a variable rate in exchange for a fixed rate. The purpose of an IR swap is reduced interest rate risk, access to inaccessible fixed-rate markets and a chance to benefit from expectations of rising or falling rates.
Why use an IR swap?
Long-term IR swaps are attractive to companies that have variable rate loans, but who, out of fear of a rising interest rate level, want to lock in the rate during the term of the loan. When doing an IR swap with the bank, the bank pays a variable rate (NIBOR based market rate excluding margin), while the customer pays the bank a fixed rate (swap rate).
IR swaps may also be appropriate in cases where a company has access to loans with a fixed interest rate in the bond market but wants a loan with a variable rate. Using a swap agreement with the bank, the company secures itself a variable rate, while the bank pays the fixed rate on the company’s bond loan.
What is the risk associated with IR swaps?
In an IR swap agreement where the customer receives payment in a fixed rate of interest and the fixed market rate rises, the swap agreement will result in a loss for the customer. If the market rate falls, the agreement will rise in value and give the customer a profit. In an IR swap agreement where you pay a fixed rate and the fixed market rate rises, the swap agreement will generate added value. If the market rate falls, the agreement will fall in value. If an IR swap is terminated before the end of the agreement, the added value or lower value of the IR swap will be settled between the parties.
Would you like to learn more about fixed-income securities and currency hedging?
DNB markets offers corporate clients a variety of methods for hedging and eliminating currency risk. Contact us to find the right method for your business. We also offer courses and training in handling commodities, interest rates and currency risk.
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