Interest Rate Swap

Havenridge Manufacturing has a large floating-rate term loan and its treasurer fears rising short-term rates. She enters a plain vanilla interest rate swap. In that swap, Havenridge would:

1. A.Receive a fixed rate and pay a floating rate, and exchange notional principal at inceptionThis is backwards for a floating-rate borrower, and notional principal is never exchanged.
2. B.Pay a floating rate and receive a fixed rate, leaving its exposure to rising rates unchangedPaying floating would compound, not hedge, the existing floating-rate exposure.
3. C.Pay a fixed rate and receive a floating rate, exchanging only net interest amounts on each settlement dateCorrect. Paying fixed and receiving floating converts the floating loan into synthetic fixed-rate debt.
4. D.Exchange the full principal balance of the loan with the counterparty at maturityThe principal is notional; it serves only to compute interest and is not exchanged.

Why: In a plain vanilla interest rate swap a borrower with floating-rate debt pays a fixed rate to the counterparty and receives a floating rate, which offsets the floating payments owed on the underlying loan and converts the exposure to a synthetic fixed rate. Only the net difference in interest amounts changes hands on each settlement date; the notional principal is never exchanged. The borrower gives up the benefit of falling rates in exchange for certainty.

Wrenbury Foods has borrowed $50 million under a bank facility whose rate resets quarterly against a floating benchmark. The treasurer is worried about rising rates and enters a plain vanilla interest rate swap with a dealer. What does the company do under the swap, and what is exchanged?

1. A.The company receives fixed and pays floating, and the $50 million of notional principal is exchanged at the start and returned at maturity.Incorrect on both points. A borrower hedging rising rates pays fixed, and notional principal is never exchanged in an interest rate swap.
2. B.The company pays a fixed rate and receives a floating rate on a notional amount that is never exchanged, so the floating leg offsets its bank interest and it ends up paying fixed in substance.Correct. Paying fixed and receiving floating converts floating-rate debt into fixed-rate debt synthetically, without touching the underlying loan.
3. C.The swap repays and replaces the bank facility, so the company owes the dealer rather than the bank after the trade.Incorrect. The underlying loan is untouched. The swap is a separate contract layered on top of it, and the company still owes the bank.
4. D.The company eliminates all risk from the arrangement, since a swap creates offsetting obligations that cancel exactly.Incorrect. It exchanges interest rate risk for counterparty credit exposure to the dealer, and it gives up the benefit of any fall in rates.

Why: In a plain vanilla interest rate swap, two counterparties agree to exchange interest payment streams calculated on an agreed NOTIONAL principal amount. The notional itself is never exchanged; it exists only as the figure against which the two payment streams are computed, which is why the credit exposure created is far smaller than the headline size suggests. A borrower carrying floating-rate debt and wanting certainty enters the swap as the FIXED-RATE PAYER: it pays a fixed rate to the dealer and receives a floating rate from the dealer. The floating leg received is designed to offset the floating interest it owes the bank, so the two floating streams cancel and the company is left paying a fixed rate in economic substance. It has synthetically converted floating-rate debt into fixed-rate debt without renegotiating or refinancing the underlying loan. The trade-off is symmetrical: having fixed its cost, the company no longer benefits if rates fall, and it takes on counterparty credit exposure to the dealer, which is why such swaps are typically collateralised or centrally cleared.