Real business example of interest rate swaps all, businesses, interest, scenario, example

sabre

Hello all,

I need some help from forum members.

I read about the basic interest rate swaps, and how if one has taken a fixed rate loan and the other has a variable interest loan, they can swap on notional amount and pay the netted amount to each other.

How does this relate to real business scenario, can anyone please explain or give a real example how this is used in real businesses.

Thanks a lot in advance.

scr879

One way of looking at an interest rate swap is the fixed payer is betting the interest rates will rise, and the variable payer betting they will fall. Its best if you look on page 380 Volume 5 as that is where a swap is initially explained.

Basically without a swap, a company paying a floating rate loan on an asset is exposed to interest rate risk which could result in a negative income spread (return on asset - funding cost)

with an interest rate swap a company can lock in a guaranteed spread on the asset and funding cost regardless of the variable rate it pays.

the example shows a company that pays the floating rate thinks the interest rates will fall (it pays a smaller amount of interest than it receives = gain). swaps can be very beneficial to both companies.

for example currency swaps are used to reduce expense volatility for companies conducting business in other countries because the exchange rate wont cause large or small expenses from period to period.

suyash1989

> One way of looking at an interest rate swap is the fixed payer is betting the interest rates will rise, and the variable payer betting they will fall.

Not really.

The market pays you to take on risk, so if you pay floating rate, your expected cost is lower than if you pay fixed rate. (compare historical average of 3m LIBOR vs 10y rate)

Depending on individual risk-reward tradeoffs, you may be more or less comfortable taking on this risk for the market-prevailing price.

If you're highly levered, facing large interest expenses, the increased risk may threaten your compliance with lender covenants or rating agencies.