A swap agreement, also known as a swap contract, is a legal contract between two parties to exchange financial instruments or cash flows. These agreements are commonly used by investors to hedge against risk or speculate on market movements. In this article, we will provide an example of how a swap agreement works.
Let’s say that Company A has a variable interest rate (VIR) loan with a payment of LIBOR + 2%. Meanwhile, Company B has a fixed interest rate (FIR) loan with a payment of 5%. Company A is worried that LIBOR rates will increase, causing their loan payments to rise, while Company B is worried that interest rates will drop, causing them to miss out on potential savings. To mitigate these risks, they agree to enter into a swap agreement.
In the swap agreement, Company A and Company B agree to exchange interest payments for a specific period of time. Company A will pay Company B the fixed rate of 5%, and Company B will pay Company A the variable rate of LIBOR + 2%. As a result, the risk of interest rate fluctuations is transferred from Company A to Company B, and vice versa.
Let’s say that the swap agreement is for a period of three years. After the first year, the LIBOR rate increases to 3%, which means that Company A’s payment would increase to 5%. However, since they are in a swap agreement with Company B, they only have to pay the fixed rate of 5% to Company B, while receiving the variable rate from Company B. This means that Company A will receive a payment of 3% (LIBOR) + 2% (swap rate) from Company B, resulting in a net interest payment of only 2% (5% fixed rate – 3% variable rate).
At the end of the swap agreement, the parties will settle the difference between the fixed and variable payments. In this case, Company B would owe Company A the difference between the fixed rate of 5% and the average LIBOR rate over the three years. If the average LIBOR rate was 4%, then Company B would owe Company A 1% (5% – 4%) on the notional amount of the swap.
In conclusion, the purpose of a swap agreement is to transfer the risk of interest rate fluctuations between two parties. In the example provided, Company A and Company B were able to mitigate their individual risks by entering into a swap agreement. This is just one example of how a swap contract can be used, and there are many other types of swaps to suit different needs and objectives.