What you need to know about interest rate swaps

There has been a lot of talk about interest rate hedging products (IRHPs) with respect to the alleged swap (and other interest rate products) mis-selling by banks, especially to small business owners. It’s imperative that we understand other businesses, their needs and compare them with our own while we also have, if not a deep understanding, a fundamental understanding of the pros and cons of the IRHPs.

In as early as July 2007, the interest rate was 5.5 per cent. After the failure of Lehmann Brothers, the global economy outlook was dim. There were liquidity and credit crunches to deal with. It’s noteworthy to remember that the Bank of England manages the monetary policy. 

When Bank of England reduces interest rate, it discourages savings and encourages borrowing. This effectively means that there is more spending in the economy. It could also boost employment. In December 2009, the MPC (Monetary Policy Committee) announced that it would reduce the interest rates to 0.5 per cent. 

The investment banks had little or no idea that this was going to be the case. Unfortunately, neither did small business owners. Some swaps and interest rate products in question were made before we expected a really bad economic climate. Long term contracts that could be potentially affected by the lowering of interest rate cannot necessarily be blamed only on the investment banks.

Interest rate risk is a risk that could affect loans. A change in the interest rate could potentially change the amount that you are repaying on your loan. There are many products that could help you hedge your risks, whilst offering you flexibility on your terms of repayment. Picking the one that’s right for your business is key. Let’s look at the plain English meanings of some of the widely known IRHPs.

Plain interest rate swap

You would enter this if you’re more comfortable paying a fixed amount of interest rate, rather than a floating one (based on the LIBOR) or vice versa. This is basically the exchange of a fixed stream of payments with a floating stream of payments. The bank merely facilitates the exchange of these payments and acts as an intermediary, connecting two parties with converse views on the interest rate (one assuming it’s beneficial to pay a fixed rate, the other believing that the LIBOR is going to go low, or be favourable to them). 

Breaking a swap contract (the exit clause) isn’t simple and you’d have to pay the “remaining cost” (mark-to-market value) on the contract.

Caps are products that protect you against a rise in IR beyond a pre-agreed upon level. Floors protect you against the risk of IR going low, beyond an agreed upon level.

Interest rate collars

These protect you against a rise in the interest rate, but you have to pay if the interest rate goes lower than a particular agreed upon level. One goes long a cap and short a floor in an interest rate collar. You would buy a collar, if you are of the view point that the interest rates are going to go up. A reverse collar would be the exact opposite scenario.

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