Beginner's guide to investing: What is a swap?

By Deputy editor Tim Bennett Jun 03, 2011

Tim Bennett

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Tim Bennett explains how an interest rate swap works - and the implications for investors.

And watch all of Tim's video tutorials here

Swaps

The way a borrower can most easily raise money isn't always best suited to their needs. Imagine two firms need to raise money. Company A might easily be able to raise fixed-interest money, but what it really needs are floating rate funds. The reverse is true for Company B. The solution for them would be an interest rate swap. Company A issues its fixed-interest bond and Company B issues a floating-rate loan.

They then agree to swap their interest payment liabilities, and so pay one another's interest and end up getting the money in the form they need it at a cheaper rate than if they had borrowed it direct. In practice, rather than finding a direct counterparty for the swap, companies will arrange it with a bank that will either find the counterparty for them or act as counterparty itself. Currency swaps are where Company A wants dollars but can get better trading terms in euros, while the reverse is true for Company B, so they swap so that each ends up with what it needs. With many swaps, both interest payments and currencies are exchanged.

• Entry from MoneyWeek's Financial glossary.

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Published in Video tutorials | More articles by Tim Bennett

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  • 1. Lee Hutchinson

    (04 June 2011, 06:23PM)  Complain about this comment

    These are very useful tutorials, be good to see more on some varied topics!

  • 2. Landlord

    (05 June 2011, 02:39PM)  Complain about this comment

    Great so you have told me all about the product I need but it is unavailable to me!! I have been trying for 2 years to find a good way to mitigate risk on the 3 million sterling I owe (BTL mortgages) and this video just rubs my nose in the fact I don't owe enough!!

    Actually a bank did offer 5% for 5 years for 100k..!! Trouble is the percentage rate was too high, the term too low and the cost ridiculous! (it would dump me back onto variable rates just when the BOE is likely to be going up again!!)

    My hedge so far has been silver as in I invested a sum equivalent to a years worth of interest payments into silver.

    But I still live in hope of finding a mechanism to give up some profit for capping the floating rate my mortgages can go up to (spread betting was one route I wondered about). No I can't remortgage - fees, terms, LTV etc prohibit this route and although I used to have 60% of my mortgages fixed they have now all reverted to a floating rate...

  • 3. Mick

    (06 June 2011, 11:58AM)  Complain about this comment

    It seems to rely on Bank B overpricing the risk factor for Company B, and the swap bank getting it right.

    It would be interesting to hear what happens if Bank B had correctly priced the risk and the swap bank was now underpricing it - I can't imagine that it's going to work out well for any of the parties...

  • 4. Tim Bennett

    (06 June 2011, 04:20PM)  Complain about this comment

    Mick - agreed. Swaps banks obviously operate in a competitive market and must get their risk assessment right. They must also get all of the swaps paperwork in place to ensure each contract is legally binding. It was a failure to do that that has caused many headaches after several big banks crashed a few years back.

  • 5. Tim Bennett

    (06 June 2011, 04:24PM)  Complain about this comment

    Landlord - yes, one of the key features of financial markets is institutional investors get all the best products (including in this case swaps) at the best rates and the retail investor is left to buy whatever offcuts the banks choose to offer that part of the market. Swaps do help bring down average mortgage costs but you are right that arranging one as a private investor is nigh on impossible.

  • 6. Jim

    (19 June 2011, 12:35PM)  Complain about this comment

    Fascinating, wonder how much the bank charges for arranging these swaps.

  • 7. ALI

    (30 August 2011, 10:47PM)  Complain about this comment

    Im in a similar scenario to "Landlord" have libor loans that appear to be increasig daily. what is thebest way to hedge?

  • 8. Mug

    (06 October 2011, 02:26PM)  Complain about this comment

    I have two companies. in 2006 one had a morgage of £1m the other a morgage of £1.25 I have variable morgages with 1% over base fixed for the life of the morgage until 2026. Worried that rates might rise I swapped 70% of each at a fixed rate of about 6%. I could cope if rates increased as a result and would still be OK if rates decreased. I can still remembers saying, they won't go below 3%. How wrong can you be? So as a result I now pay the bank about £15K a month extra. The only good thing is one swap ends next year, and the other a couple of years after that. I called it wrong on rates, but I look on it as insurance. If rates had doubled I would have been in the poo, as it is I'm just p'ed off. However my personal morgage is at base + 0.5% so in all I have quite a bit of money at the current good rates. Just hope they last so I get something back when the swaps end.

  • 9. Rob

    (29 July 2012, 04:56PM)  Complain about this comment

    @Landlord and ALI,
    Take a look at three month sterling futures contracts http://www.euronext.com/trader/contractspecifications/derivative/wide/contractspecifications-3657-EN.html?contractType=9&mnemo=L&selectedMepDerivative=7

    I believe they are highly correlated to LIBOR. As they work inversely to interest rates i.e. they are priced at 100 minus the interest rate you would need to take short positions. A specialist IFA is probably the way to go.

  • 10. Rory

    (16 November 2012, 03:06PM)  Complain about this comment

    Explanation of paradox that “everyone is a winner”. Imagine Company A is paying Libor and Company B is paying 10% fixed rate (status quo before swap). See how the "money changes" circulate after SWAP.
    (i) Company B is a risk and would be charged 10% fixed rate. Company A can get 7% fixed rate (which he does not want), but will take this to "assist" company B. So he swaps to fixed rate. There is now 3% "profit" floating around.
    (ii) Company B swaps to variable rate and so 1% of that 3% "goes" to bank B (because it is paid Libor + 1% from company B and Libor is what company A should effectively pay in the end)
    (iii) Another 0.5% of that 3% "goes" to company B to reduce its original 10% fixed rate down to a net 9.5%
    (iv) Another 0.5% of that 3% "goes" to the Swap bank for carrying the "risk" of letting bank B pay only 8.5% (it was “rated” at 10%)
    (v) That leaves 1% "profit" for company A which it "pays" to itself to give company A net Libor - 1% (and company B is already 9.5%).

  • 11. Heller

    (28 November 2012, 08:36PM)  Complain about this comment

    Excellent. Helped me and my other (over 70) understand what the ehll my dad was talking about regarding his swap deals. No longer gibberish. keep up the good work.

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