An interest rate swap involves exchanging variable (fixed) interest rates for fixed (variable) rates. For example, assume a Company issued $10,000,000 of variable-interest debt when rates were 6% and is now concerned that interest rates will increase. In order to protect against rising rates, the Company contracts with a Bank and agrees to pay a fixed rate of interest of 6.5% to the Bank in exchange for receiving variable rates.
If the variable rate increased to 6.7% on the $10,000,000 of variable interest debt, the Company’s semiannual net interest expense would be determined as follows:
Variable interest paid to creditors (6.7% $10,000,000 1/2 year) . . . . . . . . . . . . $ 335,000
Fixed interest paid to the Bank (6.5% $10,000,000 1/2 year) . . . . . . .. . . ... . . . 325,000*
Variable interest received from the Bank* . . . . . . . . . ... . . . . . . . . . . . . . . . . . . (335,000)
Net interest paid . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... . . . . . . . . . . . . . . . $ 325,000
*Rather than actually paying and receiving, the entities exchange the net difference between the rates (fixed vs. variable) in the amount of $10,000 ($325,000 vs. $335,000). This results in a net interest expense of $325,000 ($335,000 paid to creditors less $10,000 received from the Bank).
The interest swap was entered into because the Company feared that variable rates would increase. In essence, the swap allowed the Company to exchange a variable interest rate for a fixed interest rate as though they had actually issued fixed debt. As the swap continues, new variable rates will be determined and applied to subsequent semiannual interest payments. This process of determining a new rate for the swap is referred to as resetting the rate. Generally, the variable interest rate is reset at each interest date and is applied to the subsequent period’s interest calculations.
The valuation of swaps is complex and dependent on assumptions regarding future rates orprices. For example, if a fixed interest payment is swapped for a variable interest payment, the value of the swap is a function of how future variable rates are expected to compare to the fixed rate. Therefore, an estimate of future variable rates is required. Furthermore, the differences between the future variable rates and the fixed rate represent future differences that need to be discounted in order to produce a present value of the differences.