Moving on to a different example, suppose that Halliburton owes $ 1 billion to a syndicate of banks led by ABN Amro and that the principal amount is repayable after 5 years.Now, assume that the interest is payable annually and the rate is pegged at the 12 month LIBOR + 100 bases points. Suppose the LIBOR rate at the beginning of Year 1 was 5.51%. Thus, Halliburton would have to pay $ 65.1 million at the end of Year 1. Now, if the LIBOR at the beginning of year 2 rose to 6.51%, what would be the interest payable at the end of year 2?
Halliburton would realize at the beginning of Year 2 that it would have to pay 75.1 million dollars as interest at the end of Year 2. Now, if Halliburton felt that interest rates would continue to rise and that it would want to know in advance, the interest that it would have to pay at the end of Years 3,4 and 5 (for better planning and budgeting), it might want to pay interest at a fixed rate every year.
It would then have 2 options. One option would be to tell the syndicate of banks that it does not like the existing loan plan and to tell them to refinance the loan at a fixed rate. The important question here is – “If the banks forsee a rise in interest rates, why on earth would they want to give in to Halliburton’s request to switch to a fixed rate and potentially lose millions of dollars in interest payments?” The answer lies in the fact that banks charge hefty amounts as “refinancing fees”. Moreover, if the banks forsee a sharp rise in interest rates, they would simply quote a higher fixed rate o interest.
Therefore, this option seems like an expensive one for Halliburton, doesn’t it? Moving on to the next option, Halliburton could also go in for an interest rate swap.That is, it could tell a bank(not necessarily a part of the syndicate) or a counterparty, say JP Morgan, that it would pay JPM interest on $ 1 billion at a fixed rate in return for an interest on $1 billion at LIBOR + 100 basis points.JPM would then give Halliburton a quote on what the fixed rate payable to JPM would be,in this case say 7.01%.
In this case, $1 billion is called the notional amount, because the interest rates are calculated based on this amount as principal. Note that the notional amount does not change hands between the two parties (known as counterparties) involved in the swap.
Once Halliburton accepts the deal, it would have to pay JPM a fixed rate, say 7.01% p.a and get interest from JPM at LIBOR + 100 basis points. It would also have to pay the ABN Amro led syndicate at LIBOR + 100 basis points. Thus, the nett amount that flows out of Halliburton’s coffers every year is 70.1 million dollars.
This is an example of a floating to fixed interest rate swap for obvious reasons. Similarly, one could have fixed for floating swaps and fixed for fixed swaps. You might wonder, – “Why on earth would anyone do a fixed for fixed swap?Wouldn’t it obviously mean that one party swaps a higher rate for a lower rate and end up losing money?” Let us move on to the next example to understand what happens in the case of fixed for fixed swaps.
Suppose Reliance Infocomm wants to expand into the European market and needs a 500 million euro loan. Also suppose that the interest rate that Reliance would have to pay is 8% p.a. Now suppose that Lufthansa wants to penetrate the Indian market and needs to buy equipment and set up offices in India and that it needs a loan of 120 crore Indian Rupees (1.2 billion Indian rupees),which it can get only at 9% p.a. Suppose that Lufthansa,being a German carrier, can take loans in Germany at 6% p.a and Reliance,being a well established Indian company, can take loans in India at 8% p.a.
If Lufthansa borrows 500 million euro in Germany at 6% and give it to Reliance(which would then pay interest at 6% p.a instead of 8% p.a) and if Reliance borrows 120 crore Rupees at 8% p.a and gives it to Lufthansa(which would then pay interest at 8% p.a instead of 9% p.a), then both parties would save a lot of money( Lufthansa would save 12 million Rupees per year and Reliance would save 10 million euro per year). This is exactly what both the companies would do – Go in for a Fixed for Fixed swap.
Interest rate swaps are derivatives since they are “derived” from loans and interest rates. They are traded OTC (Over the Counter), which means that no one regulates these deals. Thus, interest rate swaps can be customized to suit the needs of both parties. Interest rate swaps are heavily traded derivates, accounting for a substantial portion of the revenues for many investment banks. For a rough idea of the scale of this trading, the total notional amount of US Dollar Interest swaps in 2004 was close to 40 trillion USD (Source: Wikipedia) ! The Fixed Income desks of Investment Banks generally deal with interest rate swaps.Swaps need not be confined to interest rates or cashflows. One could have Forex swaps,Equity swaps etc, but that is totally different story!