Firms could use swaps to transform a floating-rate rate loan to a fixed-rate loan. For example, a firm has arranged to borrow $50 million at LIBOR plus 25 basis points (LIBOR +25, or LIBOR+ 0.25%). However, several months later, it came to expect that interest rates will rise in the near future, and accordingly it wants to unlock the interest rate it is currently committed to. To that end, it resorts to the swap market by entering into an interest rate swap which involves the following:
- The firm receives LIBOR from the counterparty to the swap.
- The firm pays 6% as fixed-rate to the counterparty to the swap.
The effective rate, after combining the loan with the swap, would be:
Loan interest | (LIBOR+0.25%) |
Swap floating rate | LIBOR |
Swap fixed rate | (6%) |
Synthetic fixed-rate | (6.25%) |
Therefore, the company is able now to transform borrowings at a floating rate of LIBOR plus 25 basis points (bps) into borrowings at a fixed rate of 6.25%.
Similarly, a firm could use the swap market to transform a fixed-rate loan into a floating rate loan. Suppose a firm had arranged to borrow $50 million at a fixed rate of 5.5%. However, several months later, it came to expect that interest rates will drop in the near future, and accordingly it wants to lock in a fixed rate instead of the floating rate it is currently paying. To that end, it resorts to the swap market by entering into an interest rate swap which involves the following:
- The firm pays LIBOR to the counterparty to the swap.
- The firm receives 5.2% from the counterparty to the swap.
The effective rate, after combining the loan with the swap, would be:
Loan interest | (5.5%) |
Swap floating rate | (LIBOR) |
Swap fixed rate | 5.2% |
Synthetic fixed-rate | (LIBOR + 0.3%) |
Therefore, the company is able now to transform borrowings at a fixed rate of 5.5% into borrowings at a floating rate of LIBOR plus 30 bps.
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