Interest rate swap

What it means

An interest rate swap is a derivative in which two parties, usually a company and a bank, agree to exchange interest payments on the same notional principal over a set period. The most common type converts a floating rate into a fixed one: the company pays the bank a fixed rate and the bank pays the company a floating rate based on EURIBOR. The principal itself is not exchanged; it only serves to calculate the payments.

If a company has a floating-rate loan, it pays the bank EURIBOR plus a margin on the loan. Under the swap it receives EURIBOR and pays a fixed rate. The floating parts cancel out, leaving the company with the swap's fixed rate plus the loan margin. The effect resembles fixing the rate, but the swap is a separate contract that can be structured independently of the loan.

In practice the payments are not exchanged in full; only the difference is settled. If EURIBOR is above the swap's fixed rate, the bank pays the company the difference; if below, the company pays the bank. The swap thus protects against rising rates, but when rates fall the company gains nothing, because the lower loan interest is offset by the swap payment.

How it works in practice

Swaps are used mainly for larger, long-term investment loans when a company wants certainty over interest costs but the bank does not offer a fixed rate for the required period, or the swap is cheaper. In project finance, banks often require one as a loan condition to reduce the borrower's interest rate risk.

Throughout its life a swap has a fair value that depends on how market rates have moved against the agreed fixed rate. If rates have risen, the swap has a positive value for the company; if they have fallen, a negative one. In the accounts, derivatives are remeasured to fair value at the reporting date. Where conditions are met, hedge accounting can limit volatility in the result.

Before entering into a swap, it is worth comparing offers from several banks, checking that the notional and dates match the loan, and considering what happens if the loan is repaid early. The swap does not end automatically, and terminating it early can be expensive if its value to the company is negative.

What to watch out for

The biggest mistake is entering a swap without understanding its risks. Companies sometimes sign a swap that does not match their loan, for example with a larger notional or longer maturity, creating a new risk instead of protection. A swap should mirror the hedged position exactly.

Watch for costs hidden in the rate. The bank builds its margin on the swap into the fixed rate, so the company does not see it directly. Comparing with market rates or an independent adviser's review helps establish whether the price is fair. In a dispute with a bank, the key question is usually whether the company was properly informed about the risks before signing.