Interest rate swaps: a short introduction
Significance and purpose
Every entity that borrows money will be aware of the risk of rising interest rates. Interest rate swaps are used by borrowers to hedge against the risk of rising interest rates.
Investors and financial institutions enter interest rate swaps for profit, to protect their income streams from floating rate bonds against the risk of falling interest rates, or for their own drawn debt interest rate hedging requirements.
This introduction looks at interest rate swaps, with the occasional comparative reference to other interest rate derivatives products such as options (such as caps), forwards and swaptions.
What is an interest rate swap?
A swap is an exchange of cash flows. An interest rate swap is a bilateral derivative contract where two parties agree to exchange payments linked to fixed or floating interest rates that have been applied to a notional amount. The notional amount could reference drawn debt amounts or a bondholding amount.
A worked example of an interest rate swap that is linked to borrowed amounts under a loan agreement:
- A company enters into a £10,000,000 term loan at a SONIA-based floating rate of interest.
- The company wishes to fix its borrowing cost because it is concerned that the loan’s SONIA floating rate may rise adversely.
- To protect itself from the risk of such adverse interest rate rises, the company enters into an interest rate swap with a bank. Commonly the swap provider bank and the lender are the same bank.
- Under that swap, the company agrees to pay a fixed amount (for example, 5% on the £10,000,000 notional amount) and in exchange the bank agrees to pay to the company a floating rate of SONIA multiplied by the £10,000,000 notional amount. In practice, the two payments will typically be netted so that only one party will have to make a payment.
- The company ensures that the swap payment dates match the interest payment dates under the loan agreement, the notional amount is adjusted to match any amortisation under the loan agreement and it has the right to terminate the swap on a refinancing.
- The swap has the commercial effect of fixing the company’s borrowing cost, which allows the company to have certainty over its cost of funds.
Other types of interest rate derivatives
It is worth noting that other types of interest rate derivatives can provide commercially similar financial protection. These products include:
- Interest rate caps
- Interest rate floors and collars
- Swaptions (an option to swap)
- Forward rate agreements.
These can all be used for interest rate hedging purposes, and each come with their own legal considerations that can often differ substantially from interest rate swaps. Investors may also take positions in standardised exchange-traded interest rate futures for financial gain rather than for hedging purposes.
The principal United Kingdom regulations that parties will need to comply with are the UK’s implementation of the European Market Infrastructure Regulation (UK EMIR), the 2014 Markets in Financial Instruments II Directive and the Markets in Financial Instruments Regulation (together MiFID II) and the Financial Services and Markets Act 2000 and linked legislation.
UK EMIR applies to almost all UK entities that enter into interest rate swaps. It requires parties to document trades correctly, have appropriate dispute resolution procedures, report the terms of its trades to an appropriate authority or have a bank report on its behalf, check the key terms of its trades at the required times and potentially to post pre-approved types of collateral and submit trades for central clearing.
On cross-border trades, the local laws and regulations of the counterparty will need to be considered.
How are interest rate swaps documented?
- Close-out netting – most swaps are documented under a close-out netting agreement. This type of agreement enables parties to enter into multiple derivative trades with a counterparty, and the trades are together deemed to be a single legal agreement. Each party’s financial exposure under their multiple trades can often be reduced to a single net exposure, rather than multiple exposures (i.e. one for each trade) that give rise to a gross exposure. This is an important credit risk mitigation tool – a net credit exposure could be much lower than a gross credit exposure if a counterparty enters into insolvency.
- Payment netting – these agreements include payment netting terms. This means that where the two parties owe money to each other at the same time and date when they have traded an interest rate swap, the lower amount is deducted from the higher amount, and the ‘out-of-the money’ party pays the net balance to the ‘in-the-money party.’
- Industry terms – a number of industry bodies publish template close-out netting agreement terms for the private sector to negotiate to suit their individual circumstances. The International Swaps and Derivatives Association is a particularly well-known industry body in this sector.
- Interest rate swaps – linked to a separate financing arrangement. If an interest rate swap is entered into to hedge interest rate risk under a bond issue or a loan agreement, parties should pay close attention that the terms of the swap agreement and trade are consistent with that bond issue or loan agreement.
What are the common points to think about on a deal?
- Client onboarding requirements to correctly categorise a counterparty, and establish contractual agreements to comply with relevant regulations, such as UK EMIR or in the US, the Dodd-Frank Act.
- Whether the legal terms and payment cash flows are appropriately linked with another contract at all times, such as a loan agreement.
- Counterparty risk, such as credit risk over the term of the swap trade.
- Cross-border considerations.
- Particularly for banks on syndicated debt deals, the swap provider bank’s security and voting rights regarding other lenders and swap providers.
- Early termination risks that could cancel a hedge before the scheduled maturity.
- Whether there are sufficient available swap counterparties for spreading risk and obtaining competitive quotes on a range of derivative product types.
How we can help