How Banks Price Interest Rate Swaps
Table of Contents
What is an Interest Rate Swaps?
If you have a loan with a variable interest rate (SONIA/Libor/Euribor), you probably keep a close eye on rates. Changes in interest rates affect borrowing costs and can make it difficult to predict what you’ll pay. Many borrowers, currently enjoying historically low interest payments on their loans, want to extend this low cost well into the future. Fortunately, there is a product called an Interest Rate Swap that allows them to do just that.
Interest Rate Swap Contract Rate
There are many different types of Interest Rate Swap products. However, in this paper we only explore Interest Rate Swap agreements from the perspective of a business repaying a variable rate bank loan i.e., a commercial loan interest rate swap. This kind of Interest Rate Swap Agreement is also known as a “Vanilla Swap”. It is the product most commonly used for hedging against rises in variable interest rates. To ensure that an Interest Rate Swap is right for you, it helps to understand how a swap works. Here’s what you need to know:
How does an Interest Rate Swap work?
The interest on your business loan has two components; a Loan Margin agreed at the outset of the loan, plus a variable rate of interest that reprices periodically, usually quarterly. If you borrow in USD or GBP, this variable rate is normally a published benchmark rate called LIBOR, SONIA or SOFR. For euros, the equivalent is EURIBOR or ESTER. If this IBOR variable interest rate rises during the life of the loan, you pay more interest to the Lending Bank. This will impact your cashflow and profitability.
This is where an Interest Rate Swap comes in. Under the Swap, the Borrower pays a fixed rate and receives IBOR. Remember, the Borrower also pays IBOR under the loan. The two opposing IBOR cash flows match off leaving the Borrower with just a fixed rate payment under the Swap, plus the Loan Margin. See interest rate swap example below:
In practice, the Borrower still pays one interest amount comprising of the Loan Margin and variable interest rate to the Lending Bank as normal. While separately, under the Swap with the Hedging Bank, they pay or receive another cashflow. This Swap cashflow, a net settlement, is simply the difference between the cashflows on the fixed and variable legs of the Swap. As illustrated in the table below, the net interest rate should always be the fixed rate (unless there’s a floor on the variable rate in the loan).
What are swap rates?
A swap rate is the rate of the fixed leg of a swap that the receiver requires in exchange for the uncertainty of having to pay the floating rate. In an interest rate swap, it is the fixed interest rate exchanged for a benchmark rate (SONIA, Libor or Euribor) plus or minus a spread.
How to price swap rates?
The “Forward Curve” is a graph depicting the path financial markets expect IBOR to follow in the future. The market constantly updates its forecasts for this path as new information that affects the market for interest rates becomes known. A snapshot of the forward curve at a point in time provides us with a path for IBOR. This forward curve allows us to calculate the expected present value of variable interest rate cash flows into the future. In the example provided in the table below, the expected interest expense for that Forward Curve on a 3 year 10 million loan is 130,000. By solving for the Fixed Rate that also provides for an interest expense of 130,000 we are solving for the Swap Rate. In our simplified interest rate swap example, this rate is 0.43%.
Different banks quoting the same Swap structure at the same time should quote similar mid-market Swap rates. In practice though the client’s Swap rate will be higher. Hedging Banks will mark-up the mid-market Swap rate to cover costs, credit risk and of course to generate a profit. As this mark-up is largely subjective, using an advisor like Vuca Treasury will make sure that the mark-up charged by the Hedging Bank is fair.
What are the risks/considerations? Interest Rate Swaps accounting implications
Like any contractual commitment, Interest Rate Swaps carry risks. Vuca Treasury recommends that the following factors are taken into consideration when contemplating an interest rate swap for SONIA, Libor or Euribor:
Swaps don’t remove interest rate risk
They simply swap a variable interest rate expense for a fixed one. As the Forward Curve continues to adjust after you fix, the Swap’s value continues to adjust too. If fixed rates subsequently rise, your Swap will be an asset (as you are paying less than the prevailing market price). While if fixed rates fall, your Swap will be a liability. If held to maturity, this would be an opportunity cost or benefit. However, if you choose to terminate the Swap before its maturity date, this value could be very large.
Interest Rate Swaps accounting implications
Depending on how the Swap is accounted for, changes in the value of your Interest Rate Swap will either be reflected in your income statement or balance sheet. This can create some volatility in Key Performance Indicators. You may want to consider how you will treat the Swap from an accounting perspective before you transact.
Some Banks include a hedge as a condition of loan sanction. It’s important to remember that the Swap rate can move significantly while the loan is being negotiated and before financial close. This may actually impact some key terms, like your debt capacity, especially when leverage is high. Borrowers should also negotiate the Swap mark-up (spread) before signing a term sheet. Many borrowers are focused on negotiating the loan itself and, to their cost, neglect this aspect when arranging a loan. Again, using an advisor like Vuca Treasury can guide you through this process.
Documentation for Swaps for SONIA, Libor & Euribor
The industry standard documentation for Swaps is an ISDA Master Agreement and Schedule. The Schedule aligns terms in the Swap with the loan and is typically heavily negotiated. It can also be expensive and time consuming. Key provisions include language around termination events. Other important documents are the Swap Confirmation and a Credit Support Annex (CSA) which may, or may not, be required.
Floor on the loan
Quite often, lenders will include a floor in their loan documentation. This is normally set at zero, but it can be set by the Lender at a higher rate. This has been a problem for EUR borrowers (EURIBOR or ESTER) seeking to hedge their interest rate risk with a Interest Rate Swap. This is because the borrower pays the difference between the Swap rate and negative Euribor on the Swap, but doesn’t receive negative Euribor on the loan. A mismatch occurs here which results in the borrower paying an aggregate rate of interest across the swap and loan which is above the fixed rate. Since the summer of 2021, this is less of an issue for GBP borrowers with GBP Libor and SONIA exposure. See interest rate calculator below.
This mismatch can be addressed by adding a floor to the Interest Rate Swap. Interest Rate Caps aren’t affected by this structural problem and have gained in popularity when hedging EUR loans as a result. See interest rate cap and interest rate swap example below.
As swap payments can be positive or negative, the future obligations under a Swap create credit risk for both parties. While a bank may be prepared to provide a Swap contract on an unsecured basis, the borrower will normally be required to provide some form of collateral to enter the Swap. This can be straightforward when the lending and hedging bank are the same entity. This is because the Hedging Bank can secure their exposure against the underlying asset(s). Where the Lender and Hedging Bank are not the same, you may be able to find a Hedging Bank that will take on an unsecured position. However, in practice this can be difficult (or expensive) and limits Borrowers to hedging with an Interest Rate Cap.
After 2021, IBOR may cease to exist and will be replaced by new Risk-Free Rate (RFR) benchmarks (SONIA in the UK and €STR in the eurozone). If IBOR ceases to exist, Swaps will need to transition to the new replacement benchmark or settled using a fall-back protocol. Documentation on new Swaps should address how the replacement of IBOR as a benchmark will be handled.
Interest Rate Swaps are regulated financial instruments. Most banks will only enter these types of products with experienced (“professional”) clients. You may need to check your eligibility with your bank as some Banks will not provide Interest Rate Swaps to less experienced (“retail”) clients.
How VUCA can help?
Interest rate swaps are the most widely used product by larger businesses to manage interest rate risk. Borrowers transacting them can and should negotiate both the price of the Swap rate and the terms within their documentation. The Vuca Treasury team possess the knowledge and insight to ensure our clients can make informed decisions. We ensure our clients get the most appropriate hedging product at the best possible price. Unlike conflicted banks or brokers providing “advice” on products they’re selling; our recommendations are independent and unbiased. Contact us to find out more about how we can also help you.
Contact Martin Mulligan
Our client, McGarrell Reilly, who we worked with on their Charlemont Square project in Dublin 2, said “We are really pleased to have placed our interest rate caps in a timely and efficient manner and I would like to thank our advisor, Vuca Treasury, for delivering such a great result for the business”.