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Interest Rate Swaps

The American Heritage dictionary defines a SWAP as an exchange. An interest rate swap is a contract between two counterparties to exchange the interest payments on a notional amount of principal balances from floating rates to fixed rates and vice versa. The notional principal balance is normally the weighted average outstanding during the period.

Donít overthink the concept. Procedurally, all one does is calculate the interest amount under both scenarios, net the amounts together, and settle with the bank.  

Example: There were several midsize leasing companies in the northeast that specialized in multimedia equipment, and relied on interest rate swaps to match fund their loan portfolios. They leased digital multimedia equipment, costing several hundred thousand dollars each, to the post production houses and film studios. Their business models were such that most of their leases were written on fixed rate, 5 year paper, with a $1 residual purchase option. Initially, the leases were funded by floating rate warehouse lines. Semimonthly the leases were securitized. During the securitization process, floating rate debt was swapped for fixed rate debt. This way, the profit on the monthís book of business was locked in; it quantified with certainty the amount of future obligations for these companies.    

Interest rate swaps are an added value tool for most businesses. Letís go over another example. Assume youíre working for a manufacturing company that has outstanding debt under a floating rate revolving loan. Also assume that rates are low and thereís a general feeling that they are going to increase. Going back to the lenders to refinance the existing floating rate loan into a fixed rate loan is time consuming and expensive. Itís more practical just to enter into a swap agreement to exchange interest rates. The effect is the same as a refinancing; you are locking into lower fixed rate net interest payments. Itís a nice way to lower funding cost and take advantage of current and projected market conditions.

Hereís the issue: for a modest premium, you can control a large notional amount. The examples above used swaps as a hedge with a true economic use. Now suppose you donít control any notional offsetting balances and you enter into a speculative swap agreement, betting on the future direction of the yield curve. If you bet correctly it can be extremely profitable, but if you bet wrong, it can be disastrous. Timing interest rates can be frustrating. During 2004-2005, the Federal Reserve had been increasing short-term interest rates, only to discover that the markets decreased long-term rates. The government was trying to increase rates to keep inflation under control and to prevent a bubble in the real estate market, yet the markets were lowering long-term rates that were propping up real estate prices. It goes to show how difficult it is to correctly predict interest rate movements. Sometimes itís a conundrum. The leverage and risk on unhedged swaps is huge; it can be very costly if you bet incorrectly!  

 

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