Interest rate swaps

Internal Auditor, August, 1996 by Thomas E. Lynch

Interest rate swap agreements are private contracts that obligate two parties to exchange interest payments, usually every three or six months, for a set number of years. The contract is based on a notional principal amount that is never actually exchanged but serves as the reference amount against which the interest payments are calculated. Contracts for each transaction are designed to meet the end user's interest rate risk management needs in terms of maturity and interest rate.

Such contracts enable management to hedge interest rate risk; to enhance liquidity and risk management - because swaps do not involve an exchange of principal; to speculate on future movements in interest rates; and to reduce the cost of funding - because swaps are operationally more efficient to arrange and maintain. Since many internal auditors are being asked to examine these increasingly popular financial instruments, understanding the steps and parties involved is essential.

* How Swap Contracts Work

Assume that ABC and XYZ each have intermediate-term debt outstanding. ABC pays interest on this debt every six months at a fixed rate. XYZ pays interest at a floating rate, based on some referenced index like the prime rate, which is adjusted and paid every six months.

In this hypothetical example, assume ABC would prefer to pay interest at a floating rate, while XYZ would prefer to pay interest at a fixed rate. Their objective is the same: to improve management of their interest rate risk. To accomplish this, ABC and XYZ - independently and without knowledge of each other's intentions - contact a dealer, such as a bank, and request an interest rate swap. The bank draws up the swap contract, in which ABC basically agrees to pay the floating rate of interest on $100 million of XYZ's debt for five years, and XYZ agrees to pay the fixed rate of interest on $100 million of ABC's debt for five years in the same currency that ABC uses.

Thus, the swap transforms $100 million of ABC's fixed rate debt into floating rate debt, and $100 million of XYZ's floating rate debt into fixed rate debt. As a result, the goal of both companies, which is to hedge their interest rate risk, is achieved.

* The Players

The most commonly used floating rate is the London Interbank Offered Rate (LIBOR), which is the interest rate that international banks charge each other for large United States dollar loans in London. Each day at 11 A.M. London time, the LIBOR rates for different time deposits are announced. A set of hypothetical LIBOR rates for August 10, 1996 for three different time periods is shown in Exhibit 1. The most popular floating rates are the three-month LIBOR, paid and reset quarterly, and the six-month LIBOR, paid and reset semiannually.

The fixed rate of interest in interest rate swaps is based on the yields of United States Treasury notes that are equal in maturity to the maturity of the swap. For example, the fixed rate for a three-year swap is the yield on three-year Treasury notes plus a premium. An indication pricing schedule (Exhibit 2), which is reset daily, shows the yields of Treasury notes plus the premium to pay a fixed rate, the "bid," or to receive a fixed rate, the "ask." This schedule is used by traders to price swaps.

The Floating Rate Payer

Assume that company ABC has an "AAA" credit rating, $500 million of intermediate-term fixed rate debt, and a portfolio consisting mostly of floating rate assets. The treasurer of company ABC wants to match floating rate assets with floating rate debt by converting the company's fixed rate funds into floating rate funds. On August 10, 1996, the treasurer, who is an end user of swaps, calls his bank, a dealer in swaps, and tells a swap trader in a recorded telephone conversation that he wants to swap the interest payments on $100 million notional principal for five years, and wants to pay the floating rate at six-month LIBOR in U.S. dollars, and receive the fixed rate in U.S. dollars.

The Financial Intermediary

The swap trader at the bank, the financial intermediary, refers to information similar to that provided in Exhibits 1 and 2 and quotes the following interest rates for August 10, 1996:

1. ABC pays the bank six-month
   LIBOR - 4.8750% x 365/360 =                          4.9428%

2. ABC gets from the bank five-year
   T-note interest + 26-bps (basis points)              6.8520%

3. Spread in rates                                      1.9092%

The trader then makes these calculations:

4. $100,000,000 x 1.9092% =                           $1,909,200
   $1,909,200 x 183/360 =                                970,446

5. Less additional brokerage costs
   (hypothetical amount)                                 -10,000

6. Less ABC's collateral to the bank
   to be returned to ABC in five years                  -200,000

7. Net payment by the bank to ABC
   on December 10, 1996                                 $760,446

In line 1, six-month LIBOR is quoted with semiannual compounding on the basis of a 360-day year. In line 2, the Treasury note rate is quoted with semiannual compounding on the basis of a 365-day year. Thus, to make a six-month LIBOR rate comparable with a Treasury note rate, either the six-month LIBOR rate must be multiplied by 365/360, which is done here, or the Treasury note rate must be multiplied by 360/365.