Last Updated on December 29, 2021 at 5:48 pm
If you read the scheme information document of a typical debt fund, say PPFAS liquid fund, you would fund interest rate swaps mentioned in many places. An interest swap is a derivative product used to hedge interest rate risk by mutual funds. In this article, we explain with simple examples, how swaps work.
About the author: Harshini Gopu works in a global financial institution as a senior associate. She is experienced in credit risk and capital management. She is also a budding artist. In a previous article, we had explained how Floating Rate Debt Mutual Funds Reduce Interest Rate Risk. In this article, we explain in detail one particular technique of achieving this.
What are Interest Rate Swaps (IRS): An Interest rate swap is a derivative instrument which is available in the over-the-counter (OTC) market. This instrument is for institutions/companies and not for retailers. It is used between companies to swap their future interest rate payments from fixed to floating or floating to fixed interest rates.
For example, Company A is paying a floating interest rate for a loan it borrowed, and it is not happy paying the floating interest rate, and it wants to move to a fixed interest rate. A lender will not change the loans interest rate terms after entering into an agreement. How will the company A swap it’s floating interest rate to fixed? It can be done by entering an IRS agreement with another counterparty B.
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Company A has borrowed a floating interest rate loan of Rs.10 lakh from a Lender one (Banks/Other Financial institution). Lender one has lent the money for MCLR + 2% interest rate. MCLR (Marginal Cost of Funds based Lending Rate) rate is an internal reference rate for banks to determine the interest they can levy on loans. In other words, MCLR is the minimum rate that a bank can lend to a customer. MCLR depends on the Repo rate, which the Monetary Policy by RBI decides bi-monthly.
We also have another company B which has borrowed a loan from Lender two. This loan is borrowed at a fixed interest rate of 10%. Irrespective of the change in benchmark rate (MCLR), Company B has to pay the fixed-rate, i.e. 10%.
Neither companies are happy. Why? Company A thinks that their interest rate on the loans is unpredictable. It changes every year with the change in the benchmark rate. Due to the fluctuations in the floating interest rate, company A is not able to plan for how much they have to pay in the future, and they also predict that benchmark rate may increase in coming days. So, to avoid paying high-interest rates, they wanted to move over fixed interest rates.
Company B thinks that they are overpaying at a high fixed interest rate even if the benchmark rate in industry reduces and assumes that their peers are enjoying the benefit of floating rate. Also, they predict that the benchmark interest rate (MCLR) might further go down in the future, and so they wanted to switch over to a floating interest rate.
Clearly, both the companies are not happy about their interest rates, and neither of them can get out of these existing agreements with their lenders. Therefore, they decide to swap some or all of their interest rate payments with each other. Company A and B decide to enter into an agreement called interest rate swap, where company A agrees to pay a fixed rate payment of 8% to company B and company B agrees to pay a floating rate MCLR + 1% to company A.
These both interest rates are calculated on the same notional amount of Rs.10 Lakh which they initially borrowed from lenders. You may be wondering how this agreement will help both the companies to swap their interest rates. You will be clear once you finish reading this.
Mechanics of IRS The below image shows the interest rate movements between the two companies. The notional amount (Rs.10Lakhs) on which the interest rate is actually calculated are not exchanged between company A and Company B. Only the interest rates are exchanged under the IRS. The red highlighted transaction in the below image represents the interest rates swap.
When we consider the whole picture, after entering into interest rate swap, company A will be paying the fixed interest rate, and company B will be paying a floating interest rate. And let’s discuss how this works. First, let’s take a look at the payment paid and received by company A in the below table.
Based on Table 1 before entering into the IRS, company A was paying a floating interest rate. Now, after entering into IRS, Company A will end up paying a fixed amount of Rs.90,000 every year. Therefore, it has successfully swapped its floating interest rate loan to fixed-rate loan. And so the uncertainty of MCLR will not affect Company A. Now let us look at company B’s payment paid and received in table 3.
After entering into interest rate swaps, Company B now ends up paying a floating interest rate based on a change in MCLR. As predicted by Company B if MCLR falls in future, then it will be benefited from this IRS agreement. This is a simple example to understand the mechanics of interest rate swaps.
In addition, mutual funds are permitted to use forward rate agreements and interest rate futures for managing interest rate risk (see above link on floating rate funds). All transactions are regulated by SEBI and RBI.