Manage interest rate risk with a solution tailored to match a specific risk profile
Among the most popular of derivative instruments, interest rate swaps are used by corporations, government entities, and financial institutions to manage interest rate risk.
Swaps can be applied to a wide range of hedging needs and can be easily tailored to match a specific risk profile. Their simplicity and flexibility have made them the workhorse of the risk manager's toolbox.
A swap is an agreement to exchange interest payments in a single currency for a stated time period. Note that only interest payments are exchanged, not principal.
Swap terms are customized to meet the user's specific risk management objectives. Terms include starting and ending dates, settlement frequency, the notional amount on which swap payments are based, and reference rates on which swap payments are determined.
Reference rates are published rates such as LIBOR or benchmark Treasuries, or customized indexes crafted to meet the client's needs.
Why Use Swaps?
Treasurers use swaps to hedge against rising interest rates and to reduce borrowing costs. Among other applications, swaps give financial managers the ability to:
Financial institutions, pension managers and insurers use swaps to balance asset and liability positions without leveraging up the balance sheet and to lock-in higher investment returns for a given risk level.
Common Swap Structures
Other Typical Swap Applications Include:
Fixed-for-floating swaps which allow a company to lock in liquidity through issuing long-term debt, but to pay a floating rate. The swap positions the company to gain from a decline in short-term interest rates.
Forward-starting swaps to lock in the rate today for an asset or liability to be created or sold in the future. A company that plans to issue fixed rate at a future date can use a forward-starting swap to hedge the future issuance rate. Forward-starting swaps allow companies to take advantage of favorable rates when the market offers them - not just when coming to market. Locking in the forward financing costs or investment yields allow the hedger to accurately budget cash flows and expenses related to future projects.
Basis swaps to help hedgers extract value from out-of-line market relationships between different reference indexes. For example, when the LIBOR-CP swap spread is wider than actual market spreads, a company can finance against LIBOR then swap to CP, creating synthetic commercial paper priced debt at rates below those directly available in the CP market.
Swaps with imbedded options to fit unusual financing structures. For example, investor preferences sometimes favor yield enhanced securities such as callable debt. Companies can take advantage by issuing fixed rate callable debt then using a cancelable swap to convert the debt to its floating rate target at a cost below straight floating rate financing alternatives.
Other swap structures can be created to meet different needs. This flexibility is why many companies find interest rate swaps are an invaluable tool in managing the financial balance sheet.