Question

Certain features such as interest rates swaps can be included in corporate loans. Using relevant banking concept, discuss the motivation of corporate borrowers for requesting the inclusion of interest rates swaps. Give examples to illustrate your argument.     

(Please provide a 400 words explanation)

Answer 1

First, let us understand what an Interest Rate Swap is

Interest Rate Swap: An interest rate swap is a derivative instrument, which is used by two counterparties, that have agreed on exchanging a set of future interest payments for another.

Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead

Example of a swap

ABC Company and XYZ Company, have entered into a 1 year interest rate swap, of value of $1 million. ABC offers XYZ a fixed rate of 5% for a rate of LIBOR plus 1%. Both parties believe that the LIBOR will be roughly around 4% At the end of year, Company ABC will now payout Company XYZ, a sum of $50,000 (5% of $1 million). If the LIBOR rate is trading at a rate of 4.75%, XYZ then will have to pay ABC Company $57,500 (5.75% of $1 million, because of the agreement to pay LIBOR plus 1%).

The value of the swap to ABC and XYZ lies in the difference between what they receive and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a gain of $7,500, while XYZ realizes a loss of $7,500. Generally, only the net payment will be made.

Why are Interest rate swaps useful

Commercial motivations. Some companies are in businesses with specific financing requirements, and interest rate swaps can help managers meet their goals

Speculation: Hedge funds rely on speculation and can cut some risk without losing too much potential reward.

Comparative advantages: Firms sometimes receive either a fixed- or floating-rate loan at a better rate than some other borrowers. However, that may not be the exact specific kind of financing they are looking for in a particular situation. A company may, for example, have access to a loan with a 5% rate when the current rate is about 6%. But they may need a loan that charges a floating rate payment. If another company, meanwhile, can gain from receiving a floating rate interest loan, but is required to take a loan that obligates them to make fixed payments, then two companies could conduct a swap, where they would both be able to fulfill their respective preferences.