Sunday, February 15, 2015

Interest Rate Swap (IRS)

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# Readers' Question
Please explain Interest rate swap with example

An Interest Rate Swap (IRS) is a financial instrument that works in a derivative market, where two parties exchange interest rate payments between them.

IRS is useful when one party wants to receive payment with a variable interest rate, while the other party wants to limit future risk with a fixed interest rate.

Clear the concept with an example -

Suppose, two companies X and Y has come up with an agreement of Interest Rate Swap (IRS) with a nominal value of Rs. 1,00,000

Company X offers a fixed rate of 5 % per annum to Y on the nominal amount, whereas Y agrees to pay a variable rate, like Mibor rate + 2 % per annum to X in return. Note that Mibor rate changes on daily basis, making the rate a variable one. 

(Don't take the following figures of Mibor rate as actual!)

Here, both X and Y know that Mibor rate (variable) will remain roughly around 3 % (just a figure), making it almost equal to the fixed rate, i.e., 3 + 2 = 5 %. Note that X will make a profit if the Mibor rate is greater than 3 %, because in that case, Y will pay X more than 3 + 2 = 5 %. 

Conversely, if the Mibor rate is lower than 3 %, then X will make a loss, because Y will pay less than 3 + 2 = 5 %.

Clear it with figures -

CASE 1 - Mibor rate is greater than 3 %, say 3.5 %
  • Y will pay 3.5 + 2 = 5.5 % interest rate on the nominal amount (i.e., Rs. 1 lakh to X at the end of that year, making total interest = Rs. 1,00,000 x 5.5 % = Rs. 5,500 interest
  • Also, X will pay the fixed 5 % interest rate on the same nominal amount of Rs. 1 lakh, making total interest = Rs. 1,00,000 x 5 % = Rs. 5,000 interest.
Note that only the net difference is settled in case of Interest Rate Swap, meaning only Rs. 5,500 - 5,000 = Rs. 500 will be paid to by Y.
In this case X made a profit, while Y faced a loss of Rs. 500.

CASE 2 - Mibor rate is less than 3 %, say 2.5 %
  • will pay 2.5 + 2 = 4.5 % interest rate on the nominal amount (i.e., Rs. 1 lakh to X at the end of that year, making total interest = Rs. 1,00,000 x 4.5 % = Rs. 4,500 interest
  • Also, will pay the fixed 5 % interest rate on the same nominal amount of Rs. 1 lakh, making total interest = Rs. 1,00,000 x 5 % = Rs. 5,000 interest.
Note that only the net difference is settled in case of this Interest Rate Swap, meaning only Rs. 5,000 - 4,500 = Rs. 500 will be paid to by X.
In this case made a profit, while faced a loss of Rs. 500

Why IRS agreement?
  • To hedge (reduce risk) an investment
  • To earn some extra money, with a little risk (in the above example, Y agreed in IRS with X, because, he hoped that if Mibor rate gets increased, making the total interest rate (Y paying to X) greater than the fixed interest rate (X paying to Y), then he will make a profit (refer Case 2). Albeit he risked a little (refer Case 1)
    Note that the risk is less, because they both know that Mibor rate will remain roughly around 3 % (not making huge difference from 3 %. Mibor rate will never become, say, 6 % or 1 %, etc.) (just a figure). Selecting a good variable rate (like Libor, Mibor, etc.) is very much important for IRS.

Hope this article will help you learn the concept of IRS.

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Happy learning!

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