The most common and simplest swap is a "plain vanilla" interest rate swap. It involves an exchange of payment obligations by two parties in which the customer swaps the obligation to pay a variable rate of interest with a receiver who takes on the variable interest obligation and agrees that the customer should pay a fixed amount of interest. In this swap Party A agrees to enter into a loan with Party C with a floating rate of interest plus margin. Party A then enters into a swap agreement with Party B and agrees to pay party B a fixed rate of interest on a notional amount on a specific date for a specified period of time. Concurrently, party B agrees to make payment on a floating rate of interest for the same notional amount on the same specified dates for the same specified time period, and will be compensated if interest rates fall below the agreed fixed rate. There are two contracts the loan facility contract and the swap contract. These contracts are completely separate to each other.
In these contracts, the bank is divided into two separate departments. The high street department, which will deal with the customer’s loan facility, and the investment or treasury department which will deal with the swap. If the fixed or swap rate is above UK base rate, the customer will continue to pay UK base rate plus margin to the high street bank, and be compensated from its treasury department for the overpayment (e.g. UK base rate is 6%, swap rate is 5% - customer will pay 6% plus margin to the bank, and then be compensated from the treasury department for the 1% over payment).
If the fixed rate is lower than UK base rate payment to the treasury department would be the difference between the swap rate and the base rate (e.g. UK base rate is 1%, swap rate is 5% - the customer will pay 1% plus margin to the bank under the loan agreement, but also pay 4% to the treasury department under the swap).
Another common type of product is a” cap and collar" agreement. The agreement provides for a maximum rate (cap rate) and a minimum rate (collar rate). This gives the customer the certainty that he/she will never pay more than the maximum cap rate. There are many cap and collar agreements, such as structured collar, enhanced collar but they effectively work in the same way.
Similar to a cap and collar agreement, an interest rate cap with double floor allows the customer to pay a maximum and minimum rate. However, if interest rates fall below the floor rate, then the customer will not only have to pay the floor rate but also is penalised for this decrease. For example, if the floor rate was 5% and UK base rate was 4.25%, the customer will not only pay an extra 0.75% but will also be required to pay a further 0.75% under the double floor. The customer would therefore have to pay 5.75% under the agreement.
An interest rate swap / cap and collar agreement is a completely separate product from the underling loan facility and the amount "protected" is calculated on a notional amount for a specified term. An example of how this notional amount works is; suppose a customer borrows £1m for a 5 year term and enters into a swap with a "notional amount" of £1m for the same period. The customer has hedged / protected 100% of the loan by term and amount. If the customer then decides after two years that he wants to repay half of the loan facility, the notional amount will remain at £1m and so will the interest rate for the remainder of the term. Therefore, the customer will be paying £500,000 worth of interest on borrowings he does not have. This can cause problems for customers who want the flexibility of repaying their loan facilities early. The only way to terminate these products early is to pay the breakage cost, which is determined by “mark to market” valuations at the time. These can be substantial.
Services for you
Interest Rate Swaps
- Types of Interest Rate Swaps
- Avenues for Redress
- Common Problems
- The Regulatory Rules
- Key Contacts
- News & articles
Buying & Selling Your Home
Court of Protection
Divorce and Family
Health and Social Care Law
Litigation & Dispute Resolution
Pensions & Investment Disputes
Trusts, Wills and Estates