SWAP agreement exemple
Company A, pays to a lender a variable interest rate (nominal $1M) every period (LIBOR+2%). Ex: in period 1, if LIBORis 5%, Company A pays 7% or $70k to the lender in that period. In period 2, if Libor goes down to 4%, Company A pays 6% or $60k in interest.
LIBOR: One of the major benchmark for variable interest rates.
Company B borrows $1M but it borrows at a fixed rate of 8%. So each period, regadless of the period, Company B pays 8% of $1M, $80 each period.
Company A, doesn’t like the variability and unpredictability of LIBOR; A will feeling insecure for the next period payement, and company B will feel like over paying for the interest rate. B can also think that in short term, interest rates are going to be down. So that’s a bigger reason why they want to become a variable rate barrower.
These two companies can enter in an agreement that is called interest rate swap where the company A agrees to pay to B, 7% on a notional $1M loan. So notional is not going to change hand. In return, company B agrees to pay a variable rate (LIBOR+1%) every period.
So let’s think about what happens to the company A on period 1. It had to pay $70k to lender 1 and it also has to pay $70k to B but in exchange it gets $60k from B. So the net is $80k. In period 2, A pays to lender 1 60k (LIBOR(4%)+2) and $70k to B and in exchange it would get $50k from the swap agreement. So the net is $80k, there is not a change in period 2.
Company B will get $70k from A and it pays 50k to A. It also pays $80k for the lender 2. So net is $60K in period 2. (and 70k net in period 1).
So now, Company A is going to pay $80k fix every period and company B is going to pay essentially a variable rate.