A swap is a financial agreement between two parties used to exchange one type of cash flow for another type. The purpose of this agreement is to lower the cost of borrowing, at least for a certain time.
Swaps can be made to exchange a fixed rate cash flow for a floating rate cash flow or to exchange a floating rate cash flow linked to a type of index for another floating rate cash flow linked to another type of index. The index is a reference, also called Reference Rate, coupled with time (Period) and notional used to calculate the cash flow.
Basic formula to calculate a floating rate cash flow:
Floating rate cash flow = Notional X Reference Rate X Period
The most typical swap is an Interest Rate Swap (IRS) used by firms who are paying floating interests for their debt and believe there is a chance that future cash flows might increase. In other words, would like to hedge their risk linked to an increase of interest rates. In this case, the firm will enter into an Interest Rate Swap (IRS) with another party.
A water company has obtained from a financial entity a loan which will be used to finance the construction of a new water treatment plant.
The financial entity has financed the water companyâ€™s construction project with the condition that the company pays a floating cash flow referenced to this index: Euribor 3-months + 2% (margin).
Interest rate risk
The company currently has an interest rate risk because the future cash flows are not known and there is a possibility that the floating rate could rise to a point where the company would be unable to meet their obligation. In our case, if the Euribor 3-months rate is 5% then the company would have to pay an interest rate of 7% (5% + 2% margin). If the company did not budgeted for such interest rate rise and did not sell sufficient water to cover the interest amounts then the company would fail to meet their obligations.
Interest rate risk hedging solution?
To hedge the interest rate risk the company can either buy a CAP or enter into an interest rate swap (IRS) agreement with another party. The later allows the company to swap their floating rate cash flows for fixing rate cash flows.
Normally the interest rate swap (IRS) used to hedge the interest rate risk is entered with the lending financial entity. Hence the lending financial entity becomes the swap counterparty that will pay the water company the floating rate cash flow and in return the company will pay a fixed rate cash flow.
Interest rate hedging costs
The cost incurred by the company at the inception of the interest rate swap agreement is zero and fixed rate is determined by the swap rate. The later is obtained from the OTC market or the interbank market.
Access to the mentioned market data can be expensive and requires some knowledge in the use of the market-data providerâ€™s system. Many financial entities usually have access to real-time market data thus giving them a greater advantage during the interest rate swap agreement negotiation process. This might result in financial entities establishing a higher fixing rate paid by the company.
Interest rate loan and swap profiles
Continuing with our example, the water treatment company is paying Euribor 3-months plus a margin of 2% for the loan, graphical profile:
The company would like to cover their interest rate risk by entering into a swap with the financial entity who agrees to pay Euribor 3-months floating rate in exchange for receiving 3.2%. Now that the company has a swap and including the loan the following is the new graphical profile:
In our above graphic we have the blue arrow which represents the loan and the two gray arrows representing the swap. When both the loan and the swap transaction are executed with the same financial entity then a netting of cash flows is realized. Meaning that all the cash flows are added, resulting in the counterparty with the negative cash flow making the payment.
In a simple cash flow structure the loan and swap profile would look like this:
At the end of each payment period the company has to pay a fixed rate of 3.2% plus the margin of 2%. On the other hand, the financial entity has to pay Euribor 3-months. This payment structure guarantees the company to know and correctly budget the future cash flow payments. This is true if the counterparty does not default. Â In this article we will not delve into the Counterparty Risk but this type of risk is associated to a counterparty defaulting on its agreement.
Issues companies might be confronted with:
- Financial Institutions requirement: The lender normally makes floating rate loans and requires the borrower to enter into an interest rate swap agreement. The swap is not necessary because other types of hedging financial instruments exist such as a Cap. However, many times banks do not offer many hedging alternatives thus giving no choice to the borrower.
- Lack of information: Many times companies do not understand how derivatives work, ISDA agreements, procedures, fixings, etc., and obtaining information via other means can be challenging. Thus companies only option is to trust the bankâ€™s advice.
- Unable to negotiate prices: Access to real-time market data can be expensive and calculating the valuation for certain types of swaps might require advance financial knowledge. This drawback inhibits the companyâ€™s ability to verify the prices of financial hedging instruments.
- Need for derivative valuations and follow up: Any time there is a hedging restructuring or periodic presentation of financial reports, the mark-to-market of swaps has to be known.
- Testing Hedge Effectiveness: According to IFRS IAS39, hedging instruments have to pass certain criteria to prove that these derivatives are effectively hedging the underlying or in other words less risky. In the event a portfolio of derivatives do not pass the hedge effectiveness assessment test then they are considered speculative. Hedge ineffectiveness is reported in the current earnings.
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