AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E3. The use of financial derivatives to hedge against interest rate risk

E3a. Interest rate swaps - examples 9 / 13

Syllabus E3a)

a) Evaluate, for a given hedging requirement, which of the following is the most appropriate given the nature of the underlying position and the risk exposure:

iii) Interest rate swaps

Interest rate swap allows a company to exchange either:

Fixed rate interest payments into floating rate payment, or

Floating rate interest payment into fixed rate payments.

Example 1

aCOW plc has a loan of £20m repayable in one year. 

aCOW plc pays interest at LIBOR plus 1.5% and could borrow fixed at 13% per annum. 

Milk plc also has a £20m loan and pays fixed interest at 12% per annum. 
It could borrow at a variable rate of LIBOR plus 2.5%.

The companies agree to swap their interest commitments with:

aCOW plc paying Milk plc fixed rate plus 0.5% and 
Milk plc paying aCOW plc LIBOR plus 2%. 

An arrangement fee of £10,000 is charged on each company.

Required:

Calculate the total interest payments of the two companies over the year if LIBOR is 10% per annum

Solution

LIBOR at 10%

aCOW plc

£ 
Interest on own loan (10% + 1.5%) x 20m  (2,300,000)  (11.5%) 
Interest received from Milk (10%+2%) x 20m  2,400,000  12% 
Interest paid to Milk (12%+0.5%) x 20m  (2,500,000)  (12.5%) 
Total interest payment  (2,400,000)  (12%) 

Milk plc

£ 
Interest on own loan (12% x 20m) (2,400,000)  (12%) 
Interest received from aCOW (12% + 0.5%) x 20  2,400,000  12.5% 
Interest paid to aCOW (10% +2%) x 20m  (2,400,000)  (12%) 
Total interest payment  (2,300,000)  11.5% 

Calculation of arbitrage gains from the swap

Fixed rate  Floating rate 
aCOW 13%  LIBOR + 1.5 
Milk 12%  LIBOR + 2.5 
Difference  1% -1% 
Arbitrage gains =  1% - (-1%) = 2% 

Example 2

A company wants to borrow £6 million at a fixed rate of interest for four years, but can only obtain a bank loan at LIBOR plus 80 basis points. 

A bank quotes bid and ask prices for a four year swap of 6.45% - 6.50%.

Required:

(a) Show what the overall interest cost will become for the company, if it arranges a swap to switch from floating to fixed rate commitments.

(b) What will be the cash flows as a percentage of the loan principal for an interest period if the rate of LIBOR is set at 7%?

Solution 2

(a)

Actual interest floating rate (LIBOR + 0.8) 
Swap
Receive floating rate interest from bank  LIBOR 
Pay fixed rate (higher-ask price)  (6.50) 
Overall cost  (7.3) 

(b)

Actual interest floating rate (7 + 0.8)  (7.8) 
Swap
Receive floating rate interest from bank 
Pay fixed rate (higher-ask price)  (6.50)  0.5 
Overall cost  (7.3) 

Reasons for interest rate swaps

Interest rate swaps have several uses including:

  1. Long-term hedging against interest rate movements as swaps may be arranged for periods of several years.

  2. The ability to obtain finance at a cheaper cost than would be possible by borrowing directly in the relevant market.

  3. The opportunity to effectively restructure a company’s capital profile without physically redeeming debt.

  4. Access to capital markets in which it is impossible to borrow directly, for example because the borrower is relatively unknown in the market or has a relatively low credit rating.