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Interest Rate Swaps

(IRS) is a reference to financial instruments known as hedgesand derivatives.

To hedge somethingis to evade or “dodge” something.

In essence that is what an interest rate swap is; it is a hedge against the movement of interest rates.

When you hedge your bets you are insuring yourself against losing.

In its most basic form there is a vanilla interest rate swap.

Like all interest rate swaps, you “swap” interest rates with the provider of the interest rate swap.

One party (you, known as counterparty A) will pay a fixed rate.

Counterpart B (the bank) will pay avariable rate. 

When interest rates (either Bank of England base rate, your lending bank’s base rate or LIBOR) go above a predetermined Level Counterparty B(the bank) pays Counterparty A(you) money.

When the rate fall below this level Counterparty A will pay Counterparty B.

The financial effect of this is that you will have a fixed rate.

If interest rates increase above the set rate the amountspayable under the loan will increase, but the bank will compensateyou for it.

If the interest rates fall below the set rate the amounts payable under the loan will fall but youwill make up thedifference by payingthe bank under theswap.

The net off-set of payments means that you will always have the same contingent liability for the repayments under the underlying loan facility and swap.

Interest rate swapping can then be used in a many ways, limited only by the imagination.

For a capped rate a ceiling limit will be set. Counterparty A can then benefit from interest rates fluctuating, but will never pay above the set rate. 

That gives the ability to enjoy rates dropping, but always knowing that you will never pay above a certain set interest rate. 

There can be a cap and a floor, meaning that Counterparty A can know for certain that they will only pay a variable rate within set parameters. 

The interest rate can be set using a variety of indicators including, butnot limited to LIBOR (the London Inter-Bank Offered Rate),Bank of Englandbase rate and the Lending bank’s base rate.

Hedging can be very beneficial to a business when used appropriately.

However, they are very complex financial instruments.

Choosing the right level to set the rates means finding the perfect balance.

If the rate is set wrong a product designed to help the business can lead to, at worst, the insolvency of that business.

What the banks and businesses alike did not appreciate before 2008 was that interest rates would drop to 0.5%.

It certainly could not have been appreciated by anyone that interest rates would remain at 0.5% for so long, and no-one could have predicted the currentpossibility of a furtherdrop to 0.25%.

A feature of some of the swaps is that if the set rate fell below a specified point, say 3%, then Counter party A would pay Counter party B additional sums.

This came as a surpriseto the parties subjectto these strictures.

While the rest of the country benefited from cheaper lending facilities businesses subject to these kinds of swaps were being crippledby increased payments.

Their businesses had been hit hard by the deep recession but then found that their cash flow was taken up paying money to the bank under the swap.

Whilst business was in decline, those who were bound by swap agreements were having to pay increased outgoings to their banks.

As stated, “interest rate swaps” is a term used to cover all swaps.

There are also LIBORswaps, knock in floor,caps, structured collars,debt default swaps,foreign currency swapsand many more.  

If you have any kind of swap agreement, we can assist you.

We have found that as a result of the fall in currency levels clients subjected to foreign currency swaps have been unable to compete in the market because they are fixedin to a set currencyexchange rate, but thecost of exiting theSwap is large.

Contact Rate Swap Refunds today for a no obligation discussion, regardless the form of swap you have.

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