Swap banks are financial intermediaries, similar to brokers, operate to match deals between counterparties who enters into an interest rate swap agreement. Entering into a swap agreement reduces the cost of lending for both the firms involved in the contract as well as to the banks. The company borrows at a floating rate a bank offers, where the requirement is a fixed rate loan. A swap is a derivative contract exchanged between two parties on agreeable terms.
Entering a swap agreement
Company A which is well established and approaching the mature state of business. The security of the firm entices long term investors because of its financial stability. Now willing to borrow at a floating rate, most probably LIBOR. The company has opted to enter an interest rate swap agreement and chooses to borrow at the fixed rate loan from its primary bank. The company is expecting lower LIBOR for the lending term or to escape the interest rate risk.
Company B on the other hand is a mid-grown firm with a shaky financial but is capable servicing a fixed rate loan. The company cannot handle differential cash outflows and is rational on capital spending. Timing the cash flow remains as one of the main objectives of capital budgeting. The company has opted to enter an interest rate swap agreement and chooses to borrow at the floating rate loan from a bank.
Company A is offered a fixed loan and a floating rate loan at 7% and LIBOR respectively, and chooses to get a fixed rate loan.
Company B is offered a fixed loan and a floating rate loan at 10% and LIBOR + 1%, respectively, and chooses to get a floating rate loan.
Swap banks make a deal to pay LIBOR and the company B in return will have to pay 8.5% including the fee. The swap bank will pay the company A 8% and the Company pays to LIBOR the swap bank. The difference in the transactions is made and not the exact interest payments.
On an aggregate Company A gets an extra percentage by entering a swap agreement and an outflow of LIBOR-1 is the outflow as interest payment to the lending bank. The payment is a variable rate and is lesser than the original variable rate offered by the bank of company A.
Company B gets LIBOR and 8.5% plus the loan interest margin of 1% is the outflow, a total of 9.5%, which is lesser than the fixed rate offered by the bank of Company B.
How swap banks make money?
Swap banks can offer the Company A 7% to make a profit of 1% on every transaction, which pushes the interest expense of the company. The bank negotiates with Company B for a higher interest rate payment until the cost of fixed loan is not exceeded because one of the purposes of entering an agreement is to get a lower cost of lending. Company A to be paid with 7% and charge more from Company B to maximize the profit from transacting two interest rate swap. In this example the bank charges the weaker company, but the interest rate swap has been performed with both the parties, the whole swap agreement is favoured to the larger firm apart from the lending cost.