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How Banks Price Interest Rate Swaps 2023

Table of Contents

What is an Interest Rate Swaps?

A common swap structure in CRE finance is a pay-fixed swap, in which the borrower pays a periodic fixed-rate (quarterly in UK & EU) and receives SONIA/Euribor in return. This structure complements the underlying payment structure of many CRE floating-rate loans and, in conjunction with a floater, gives a borrower a fixed-rate profile. The SONIA/Euribor cashflows that the borrower receives on the swap net out the SONIA/Euribor component of the loan interest and the borrower is left with a net fixed rate.

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?

If you have a business loan, the interest you pay has two parts: the Loan Margin, which is agreed upon when the loan is taken out, and a variable rate of interest that changes periodically, usually every quarter. If you borrow in EUR or GBP, this variable rate is typically based on a publicly available benchmark rate such as LIBOR, SONIA, or Euribor. For euros, it’s usually EURIBOR or ESTER. If the IBOR variable interest rate increases during the loan’s term, you will pay more interest to the Lending Bank, which could negatively impact your cash flow and profitability.

To address this issue, you can consider an Interest Rate Swap. With a Swap, you pay a fixed rate and receive IBOR. However, you still have to pay IBOR under the loan. The two opposing IBOR cash flows balance out, leaving you with only a fixed rate payment under the Swap, plus the Loan Margin. Here’s an example of an interest rate swap:

Interest rate swap Sonia

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? 

In a swap, the swap rate refers to the fixed rate that the receiver requires in exchange for the uncertainty of having to pay the floating rate. In an interest rate swap, this refers to the fixed interest rate that’s exchanged for a benchmark rate (such as 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%.

Interest Rate Swap example

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.

Interest rate swap Image

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. 

Interest Rate Swap Fixed

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.

Interest Rate Swap and Cap Example

Credit Risk

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.

IBOR Replacement 

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

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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”.

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McGarrell Reilly