Overview
A short summary of interest rate swaps and how they are priced
Last updated
A short summary of interest rate swaps and how they are priced
Last updated
Interest rate swaps are derivatives that enable borrowers to hedge their interest rate risk. This risk arises when a borrower takes out a floating-rate loan, typically from a bank or a debt fund. By entering into a swap, borrowers can mitigate exposure to fluctuating interest rates.
An interest rate swap consists of two sets of cashflows:
The Floating Leg
The Fixed Leg
Payments to the lender during the loan term are split into:
Capital repayment: A fixed amount determined at financial close (FC), often through a DSCR sizing technique.
Interest payment: A floating market interest rate (e.g., LIBOR) plus a margin.
When the project enters an interest rate swap, it pays a fixed rate to the hedge bank and receives an amount equivalent to LIBOR + margin over the loan’s lifetime.
👉🏽 Pro Tip: Always request a breakdown of the swap rate into its three components for full transparency: Swap rate = Mid-rate + Execution spread + Credit spread
At the start of the swap, the Net Present Value (NPV) of the swap (before adding spreads) is set to zero:
The PV of the floating leg is calculated using the IBOR curve, with an overnight rate (e.g., ESTR or EONIA for EUR) used for discounting.
The resulting fixed rate is called the mid-rate.
After determining the mid-rate, the final swap rate includes two additional spreads:
Execution spread: Compensates the trader for liquidity risk.
Credit spread: Compensates the bank for credit risk.
By understanding these components, borrowers can make informed decisions and ensure transparency in their hedging strategies.
