Using interest rate swaps to hedge the risks of interest rate fluctuations

Last update

An interest rate swap is an agreement between 2 parties agreeing to exchange one regular stream of interest from a fixed rate contract for another regular stream of interest from a variable rate contract for a specific period and on the basis of a predetermined amount. Therefore, the parties do not swap the notional amount, but only the agreed interest rate structures.

Who is concerned?

This is intended for medium or large borrowing businesses that want to change their interest rate structure by going from a variable rate structure to a fixed rate structure (or vice versa) depending on how they expect interest rates and their situation to change. They can use an interest rate swap as:

  • an instrument for hedging an investment:
    • swapping a variable rate for a fixed rate;
  • an instrument for hedging a loan:
    • setting the interest rate for standard credit or loans with a variable or adjustable rate (roll-over credit);
    • setting a lending rate to finance an investment that is planned but not yet carried out, etc.

For the risk of interest rate fluctuations to be hedged, the business must go from a variable interest rate to a fixed interest rate.

Prerequisites

Presentation of the application

Explanation of the underlying financial transactions to the bank.

Guarantees

Some interest rate hedging transactions represent a credit risk for banks, causing them to analyse the applicant business and submit the application to the credit committee. It is not, however, customary for the bank to request tangible guarantees for this type of transaction.

How to proceed

Duration and payment

Amount

Minimum amount required.

Duration

Short to medium-term;

duration of between one and 5 years; exceptionally, up to 20 years.

Payment of a balancing amount or differential

On each due date, the variable rate is compared to the fixed rate:

  • if the variable rate is higher than the fixed rate, a business that has opted for the fixed interest rate via the swap will receive an amount equal to the difference between the 2 interest rates from the counterparty;
  • if the variable rate is lower than the fixed interest rate, a business that has opted for the fixed interest rate via the swap will owe the counterparty an amount equal to the difference between the 2 interest rates.

The amount to be paid is calculated on the basis of the notional amount and for the period concerned.

Set-up times

The reviewing and processing times depend on the complexity, size and urgency of the case.

Advantages, disadvantages and risks

Advantages

  • the borrowing (lending) business is protected against an excessive rise (fall) in interest rates by a guaranteed maximum (minimum) rate;
  • flexibility: it can be adapted to the business’ debt structure (amortisation, repayment, type of variable rate);
  • possibility of reversing the transaction at any time given that it is a very liquid market and in the event of early repayment of the underlying credit;
  • easy to manage, recorded off-balance sheet for the business.

Disadvantages

  • no possibility of benefiting from a favourable interest rate fluctuation between the determination date and the settlement date;
  • separation from the underlying loan (investment), meaning that the hedging continues to be effective even if the underlying no longer exists.

Risks

No swapping of the principal amount and therefore risk limited to the difference between interest rates.

Your opinion matters to us

Tell us what you think of this page. You can leave us your feedback on how to improve this page. You will not receive a reply to your feedback. Please use the contact form for any specific questions you might have.

Fields marked with an asterisk (*) are mandatory.

Did you find what you were looking for?*
How would you rate this page?*
Very poor
Very good

Leave a comment to help us improve this page. Do not provide any personal information such as your email address, name, telephone number, etc.

0/1000

Please rate this page

Your opinion has been submitted successfully!

Thank you for your contribution. If you need help or have any questions, please use the contact form.

Would you like to help us make digital public services more user-friendly by submitting your suggestions for improvement?

Then visit Zesumme Vereinfachen, the online participation platform dedicated to administrative simplification in Luxembourg.

Let's simplify things together

An error occurred

Oops, an error has been detected during your form processing.