What is an interest rate swap?
Cap with adverse floor
Interest rate swaps are typically transacted by borrowers with floating rate loans, effectively converting the floating rate loans into fixed rate loans.
A swap combines an interest rate cap in the borrower’s favour with an interest rate floor adverse to the borrower. A swap is analogous to an interest rate collar with its cap and floor rates set at the same level, the swap rate.
When the floating rate is higher than the swap rate, the borrower receives payments under the swap. The further that the floating rate exceeds the swap rate, the greater the payments received by the borrower.
When the floating rate is lower than the swap rate, the borrower makes payments under the swap. The further the floating rate falls below the swap rate, the greater the payments made by the borrower.
The borrower effectively pays for the interest rate cap element of the swap by simultaneously selling the interest rate floor element. There is generally no upfront premium payable for the swap because the cap and floor elements tend to be priced at equal and opposite value.
The cap element protects the borrower if interest rates rise. But the adverse floor element exposes the borrower to risks if interest rates fall.
The risk of the swap is that, if interest rates fall, the borrower may become trapped in an expensive arrangement which may be difficult to exit without incurring potentially substantial break costs.
The adverse floor element of the swap may also impact the borrower’s loan-to-value position.
How is the swap premium paid?
Upfront or as a spread
There is usually no upfront premium payable for a swap. This is because the market swap rate is the rate at which the cap and the floor have equal and opposite value.
However, the lender may retain a swap margin by transacting the swap at a spread above the market swap rate.
The swap margin tends to vary according to the specific details of each transaction but is not normally higher than 0.5% per annum.
How are swaps priced?
Factors influencing the swap rate payable
The market swap rate is the rate at which the cap and the floor have equal value.
There are two key factors determining the swap rate payable by a borrower: the market swap rate and the swap margin applied by the lender.
Market swap rate: the market swap rate reflects market expectations regarding the future path of interest rates. Market swap rates for selected maturities are published each business day on the Bank of England’s website.
Swap margin: the swap margin tends to vary according to the specific details of each transaction but is not normally higher than 0.5% per annum.
The swap rate payable by a borrower is the market swap rate plus the swap margin.
For a given swap structure (amount protected, duration, reference rate and payment frequency) the market swap rate will fluctuate over time based on changes in market expectations regarding the future path of interest rates.
What are the risks of swaps?
Break costs and contingent liabilities
Interest rate swaps expose borrowers to risks.
If interest rates fall, the borrower may become trapped in an expensive arrangement. The borrower may find it difficult to exit the swap without incurring break costs.
The break costs of swaps can potentially be substantial as a percentage of the amount hedged.
The adverse floor element of the swap may also impact the borrower’s loan-to-value position. The contingent liability created by the potential break cost of the swap effectively adds to the amount being borrowed.
In some circumstances the contingent liability can lead to breaches of loan-to-value covenants and place the borrower in default of their loan obligations.